Another question people like to ask is not which stocks you should own but also how much you should allocate to your investments. This question is very important, especially today with a stock market that is trading near all-time highs at what appears to be disturbingly unsustainable valuations.
As investors have very different goals and characters, it is difficult to have a standard rule on how to allocate your portfolio to individual stocks. However, Mohnish Pabrai, one of the greatest investors of our generation, has came up with a fixed rule. The 10% rule, which proposes that this is the largest allocation in your portfolio when you have a great investment idea.
Whenever we have what we think is a infallible investment idea, we want to bet as much as possible into it for greater returns. At the same time, however, you must also stay humble and know that you can be mistaken. This is why you shouldn’t allocate more than 10%. The stock market and the financial world can easily blind us and the various biases we’re exposed to does not help the process of making rational decisions. Success stories about people making dumb bets and winning always tempt us to do the same.
Many businesses that we invest in have many workings below the surface that are very difficult to find, let alone understand. Most of the time, we underestimated the amount of work it takes to study a company and the factors that determine its fate.
I’ve followed the 10% rule as part of my portfolio allocation strategy. Since the start, I’ve had good years where I will regret not buying more than 10% in my best ideas, and bad years where I counted myself fortunate for adhering to Mohnish Pabrai’s rule. Perhaps, the very best outcome of following the 10% rule has been that I have encountered a lot less stress. Imprudent risk-taking may lead you to one-off success, but the consequence of failure could be huge.