How to Allocate Your Portfolio: A Framework for Investors
Contents
Check out the full video on YouTube, if you prefer reading however, keep scrolling.
When building an investment portfolio, one of the most common questions is: How should I allocate my money across different stocks? The answer depends on your knowledge, experience, and investment goals. In this article, we’ll explore a practical framework for portfolio allocation, drawing on insights from legendary investors like Warren Buffett and Charlie Munger, as well as real-world examples from my own portfolios.
Value Investing Risk & Reward Quadrant (check all the stock analyses)
The Role of Diversification: Knowledge Matters
Diversification is often touted as a key strategy to mitigate risk. However, as Charlie Munger famously said, “Diversification is for those who don’t know anything.” Warren Buffett echoes this sentiment, referring to over-diversification as a strategy for “know-nothing investors.” While diversification can help preserve wealth, concentration is what builds wealth. The level of diversification you need is directly tied to your understanding of the businesses you invest in.
- Less than 10 years of investing experience?
If you’re relatively new to investing, it’s wise to diversify more broadly. A portfolio of 10 to 20 positions can help reduce the risk of mistakes caused by limited knowledge. This approach allows you to learn and compound your understanding of different businesses over time. - 10 to 20 years of experience?
With a decade or more of experience, you can afford to concentrate your portfolio. A focused portfolio of 5 to 10 high-conviction positions is often more effective at this stage. - More than 20 years of experience?
Seasoned investors with deep knowledge of specific industries or companies can afford to be highly concentrated. At this stage, you’re likely investing in your best ideas and adding positions strategically over time.
A Practical Framework for Portfolio Allocation
To put this into practice, I use a three-portfolio approach, each tailored to different levels of knowledge and risk tolerance:
- Diversified Portfolio (10–20 positions):
This is ideal for investors who are still learning or prefer a lower-risk approach. For example, my diversified portfolio includes 15 positions, with allocations ranging from 1% to 3% per stock. These are smaller, “learning positions” that allow me to explore new businesses while maintaining a margin of safety. If a stock performs well, I can increase my position; if it underperforms, I can buy more at a lower price. - Model Portfolio (5–7 positions):
This portfolio is designed for investors with moderate experience. It focuses on high-quality businesses with strong earnings and dividends. For instance, I hold legacy positions like Archer Daniels Midland (ADM) and Rubis, which have consistently delivered returns over the years. The goal here is to balance growth and income while maintaining a concentrated focus. - Personal Portfolio (3–5 positions):
This is my long-term, high-conviction portfolio. I aim to add just 2–3 exceptional businesses per decade, building a portfolio that will compound wealth over 20 years or more. These are companies I deeply understand and believe will deliver outsized returns.
Key Drivers of Allocation Decisions
When deciding how much to allocate to each position, I focus on two critical factors:
- Margin of Safety:
This is the difference between a stock’s intrinsic value and its market price. A larger margin of safety reduces risk and increases potential returns. For example, I’m currently watching DHL, which offers a 9% return but could drop further in a European recession. If it falls another 40%, it would become a compelling buy. - Driver of Returns:
I prioritize businesses with strong earnings growth, reliable dividends, and a history of value creation. For instance, I’m interested in companies like Petrobras (an oil play) and Kraft Heinz (a dividend stock), but I’m waiting for better entry points to maximize returns.
Real-World Examples: What I Own and Why
Here’s a closer look at some of the stocks in my portfolios and the rationale behind them:
- Archer Daniels Midland (ADM):
A legacy position with a strong dividend history. I’m holding this for its consistent growth and income potential. - Rubis:
A mid-sized position with an 8% dividend yield. I’m prepared to buy more if the stock drops further, especially in the event of an oil crisis. - DHL:
Currently on my watchlist due to its attractive dividend and potential for growth. However, I’m cautious about European economic risks. - Petrobras:
An oil play I’m monitoring for a downturn. If the company survives a potential oil crisis, it could offer significant upside. - Verizon:
Despite its high dividend yield, I’m avoiding Verizon due to its heavy debt load and sensitivity to interest rate changes.
Building Your Portfolio Brick by Brick
There’s no one-size-fits-all rule for portfolio allocation. The key is to build your portfolio gradually, focusing on businesses you understand and that offer a margin of safety. Here’s how to get started:
- Start Small:
Begin with smaller positions in businesses you’re still learning about. This allows you to gain experience without taking on excessive risk. - Focus on Quality:
Prioritize companies with strong earnings, reliable dividends, and a history of value creation. - Be Patient:
Wait for the right entry points. If a stock is overvalued, don’t rush in. Patience often leads to better returns. - Monitor and Adjust:
Regularly review your portfolio and reallocate based on changing market conditions and your evolving knowledge.
Final Thoughts
Portfolio allocation requires a balance of knowledge, patience, and discipline. By tailoring your portfolio to your level of experience and focusing on high-quality businesses with a margin of safety, you can build a portfolio that aligns with your financial goals. Whether you’re a novice investor or a seasoned pro, the key is to keep learning, stay focused, and invest with conviction.
As Warren Buffett once said, “Diversification may preserve wealth, but concentration builds wealth.” So, take the time to understand your investments, and don’t be afraid to concentrate your portfolio when you find truly exceptional opportunities. Over time, this approach will help you achieve the financial success you’re aiming for.
Intrinsic Value Calculation Template by Sven Carlin (free download on Value investing course)