Portfolio Construction and Position Sizing

I share my thoughts on portfolio construction, position-sizing and diversification.

Portfolio Construction and Position Sizing
Modern Growth Investing Portfolio Construction & Position Sizing
Disclaimer: The information provided is not financial, investment, tax, or other advice. Nothing contained constitutes a solicitation, recommendation, endorsement, or offer to buy or sell securities or other financial instruments. For more information, read the disclaimer.

Hey everyone, I wanted to share my thoughts on Portfolio Construction and Position Sizing this weekend.

Let's first look at how I construct my portfolio.

The main issues to tackle when constructing a portfolio are:

  • How many positions should I have?
  • Diversification is based on factor value, growth, momentum, industry/sectors, etc.

How many positions should I have?

To answer this question, let's consider 3 approaches, less than 10 positions, between 10-30 positions, and more than 30 positions.

When you have less than 10 positions, you are incredibly concentrated in most of your holdings. This is a good approach if you are incredibly confident about these 10 positions and can hold through massive downturns like current times.

Look at the above image. Can you handle an 85% drawdown in your top 10 positions? If yes, I believe it's mostly because you invest in large-cap companies with wide moats. Otherwise, like with Affirm above, which I would classify as a midcap/Smallcap, it's challenging, if not impossible. You also have to be aware of the business is not going to get disrupted due to flux/change in external conditions.

People who preach concentration are one black swan event away from getting blown out. Many significant funds and investors that are heavily concentrated blow up like this. Also, think of the emotional consequences; you will have a tough time sleeping at night with an incredibly concentrated portfolio.

If you have anything between 10-30 positions that are appropriately sized, you will have a portfolio that lets you sleep at night and doesn't blow up your entire net worth. You will be able to follow these businesses without getting overwhelmed and always have options to deploy capital to other positions if one/few positions are not working out. I am biased here, and I feel this is the sweet spot for a generalist investor(an individual who invests across asset classes, styles, sizes, sectors, and around the world)

If you have more than 30 positions, you will have to deal with shallow knowledge about the businesses you invest in and might have a tough time holding through drawdowns as you are not highly familiar with some positions to hold them through the drawdown. I get around this by having a minimal tracker and 1% positions that don't matter that much but are a good source of ideas to deploy more capital according to flux in the market.

Diversification based on Asset Classes

Usually, people diversify across stock, bonds, crypto, and other asset classes. I am purely focused on owning businesses, so stocks it is for me.

Although I want to buy some Bitcoin sometime in the future(at an opportunistic time), owning this asset class is somewhat political, and I stay away from this.

Diversification based on Business Size

Many people like to diversify based on smallcap, midcap, and large-cap, i.e., business sizes. This is a good strategy if you are looking for more stable returns over a long time, primarily investing in large caps. But this also means you are limiting your return to generally 10-20%.

I don't believe in this. I invest across early-stage businesses(no revenues[rarely], no FCF, no profits but high growth), small caps, and midcaps. I rarely consider large caps if I can get a return of 25% from them(Looking at you, Netflix).

Diversification based on factor value, growth, momentum

"Value" is where you exploit mispricing in a business to extract value from that business. This might or might not accompany growth. "Growth" is where you ride a business that keeps growing and expanding over long periods of time. And "Momentum" is where you either ride exceptional operational excellence and fundamentals of a business over time or just the perception of fundamentals/excellence for short periods of time(don't care about long-term fundamentals; just ride the bull market or price action).

I have dabbled in all three, and I have found both growth and value sustainable investment strategies. I just hate that a lot of value businesses are run by capitalistic folks, whereas my style is more mission-driven. I lean heavily on growth here but might consider it if it's a "value monopoly/oligopoly."

Check this out, what sort of an investor are you?

Diversification based on industry/sectors/global markets

This is where you "Di-Worseify" across industries/sectors/regions worldwide. A word of caution here, if you don't know much about the industries/sectors/regions worldwide you are diversifying across and don't use those products and services, you will get wrecked. Sometimes staying in your lane is the best margin of safety you will ever have.

Again, I span across everything here, but I am primarily focused on technology and innovation and not the "label" or industries/sectors/regions worldwide.

Thoughts on Diversification in General

I am a bottom-up investor, which means I focus on the business and its industry, but I blatantly ignore trends, macro, and other types of garbage that are peddled by people(Surprising, how rampant this is, maybe not surprising as people like to crowd and "support" each other). I also span different business sizes, factors, sectors, and regions, so essentially a generalist business owner.

I would recommend everyone to have a quantitative and qualitative checklist of criteria they are comfortable with and can spot mistakes in and keep adding to these over time as you learn more and make more mistakes(I know you have made some, I have too, chill, this is how we learn).

Now, Let's look at how I size my positions.

My position sizing is purely based on qualitative factors. The positions I usually have are the following:

  • Tracker position - A position to follow the business, keep up with news, and learn more about the business and the industry. This is usually one share. Think of this as a proxy for keeping a watchlist.
  • 1% - I upgrade the position to a one percent position if the business passes through most of my qualitative and quantitative checklist items. The items that cannot be checked are usually unknown/uncertain at that time, and I am okay with that. (Psst, this is where opportunity resides, people will discard it, but managing uncertainty is a core competency for growth investing. If you can't work through this, keep the business at a tracker position)
  • 3% - This upgrade means that I have high conviction in the success of this business, and I lay out some metrics and targets(like for the next 3/5 years 30%+ growth).
  • 5% - Upgrading to this level is rare; usually, my positions grow into this percentage over time. If I upgrade a position to this by allocating capital, it usually means it's an incredible opportunity to buy due to market sentiment(Palantir and Roblox went through this in my portfolio recently), and I feel they are going to be a monopoly in a vast market and would be an excellent investment for the next decade. Observe the time horizon here; very few businesses will be at this level.

Due to this highly stringent position sizing criteria, my maximum downside on any position is limited, whereas my upside is tremendous. In effect, I am trying to give the best opportunities available to all my capital.

Now, you might say how you can generate a decent return with so many positions?

Now, this is where most people will dismiss my strategy for portfolio management and position sizing. All I want to say is:

I am looking for an asymmetric payoff where a business goes from 1 to 100, like from $100M in revenues to $10B in revenues, so out of the many positions I have, only one has to pay back my initial investment. And even if I have 40% - 60% accuracy in my picks, I would have an incredible ROI on my initial investment. I am looking for capital appreciation, not capital preservation. Capital is fucking useless; look at Google, Microsoft, Apple, and Amazon's Balance sheets, more than $50B in cash, they don't know what to do with it. My businesses are innovating and building products and services that are beneficial to customers, take care of employees and shareholders and are mission-driven to achieve outsized outcomes. Revenues and profits are a side-effect. At the same time, I believe this is not for everyone.

Also, a core tenet I practice is never to sacrifice quality. The numbers are usually clouded and hazy and can make it hard to see the light, but the quality is crystal clear; you know when you have something special, it will just hit you in the head about what a great opportunity it is.

Check out some of my deep dives below to learn a lot of qualitative and quantitative insights about high & hypergrowth innovative businesses.

Deep Dives - Modern Growth Investing

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Thanks, take care.
Chet @ Modern Growth Investing

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