Importance of Trade Management (Part 1)

Rethink investment success with this article advocating a shift from obsessive stock picking to strategic capital allocation.

What is the first thought that comes to mind when someone says he created a good amount of money in the equity market?

After speaking to a few people, I’ve understood that the first thing that most of us think is which is that particular stock or a few stocks that he got lucky with?

Sometimes I even fall into this trap even after knowing the business inside out for the last decade. So it's perfectly normal to feel like that. 

Because in investing it’s a norm, a few stocks generate maximum returns in the portfolio. And our default way of thinking is to somehow just find those stocks. It’s the right approach. Only then, we will work long hours to find out the next multi bagger.

However, there's a slight catch here.

Think about this - when you are only focussed on stock picking, you often tend to miss out on developing the conviction of capital allocation.

Now you might be thinking that there are too many jargons in the very beginning of the article. That’s because the writer is merely defining some terms at the beginning so that the article can become a breezy read.

What is capital allocation?

Simply put, if you have Rs. 100 to invest and 5 stock ideas to invest in. Now, you can either invest Rs. 20 equally in all of them. That’s equal weighted capital allocation.

or

The Dynamic Capital Allocation - where you will define some parameters to invest Rs. 100 based on your conviction and research on the stock ideas.

Hence, your investment returns are based on 2 most important factors. First is investing in the right stock and second is your bet size (dynamic capital allocation).

What happens in our investment journey is that we are too focused on stock picking. Our conversations are also based on which stock doubled in a few days or tripped in less than 6 months. We are constantly focussed on that.

Because we define our investment success in finding that solid stock that outperformed everyone else in a matter of a few days.

So every time I tell people that my full time job is wealth and investment management, their first question is give us the name of some stock. And to the other person’s disappointment, I have to tell them that I don’t know. At which point, he thinks I’m a lucky dud and leaves me alone. 

I’m happy being the lucky dud because if you ask me, I tend to give more importance to capital allocation rather than stock picking.

Why?

Because a few good stocks are enough!

Not every business will succeed over a long period of time. It’s the law of the land. An investor has to really accept this sooner or later. And the sooner you accept, the better are your odds at success are.

World’s greatest investor - Mr Warren Buffet has made his massive fortune from a few good stocks such as GIECO, Coke and Apple to name a few. Because these companies performed massively that his failures don’t really matter.

You don’t need to believe me, here’s the math!

Let’s take a simple portfolio. Suppose you start with Rs. 15 lakhs and decide to allocate an equal amount of Rs. 1 lakh per stock. So now, you have 15 stocks with an investment of Rs. 1 lakh each.

Our regular thinking tells us that in order for this portfolio to triple in value, we need every stock to triple. Some of us who are more advanced in our thought process will say that not every stock can triple but there has to be a reasonable return. No stock should go into a negative zone.

This is our usual approach. We don’t want any stock to be in the negative. It’s hard to digest the fact that we went wrong somewhere in our assessment. 

But that’s not the case. Look at the table closely.

If you can do the math, then all you need is 4 or 5 good stocks to outperform, and the rest 3 or 4 stocks to hold the ground. While the rest can underperform our expectations or even be in the negative, it won’t affect the overall portfolio.

This is the kind of investment thinking that I want you to develop. Only 40% of your portfolio should knock the ball out of the park. 

So how do you really find those 40% and really invest heavily in them?

This is the part I would like to cover in the 2nd part of this series of Trade Management. 

Keep Reading! Keep Investing!