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December 3, 1998

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Subject: Re: Foolishly overweighted.
Author: jrhii

Risk vs. Reward in Rule Breaking Investments

All over TMF people seem to be debating the Rule Breaker Port and it's heavy weighting in AMZN and AOL. This is a very significant discussion to be having in our shared experience of becoming Foolish Investors.

David has made it pretty clear that this is the result of letting winners run. Let me put this forward in a slightly different light. When I first purchase shares in a company that I believe has great long-term prospects (based on whatever measures I feel are most important for my investment goals) I am presumably going to invest a sum of money that makes sense in the context of my current portfolio.

If I've been doing this for some time, and own 8 to 12 stocks (which seems like a manageable number to me that still provides room to be somewhat diversified), it seems unlikely that I'd want to put more than around 15% of my account into a new investment.

  "So I'm actually saying that the percentage of my port that one stock has grown to occupy is simply not an issue."

Okay, that makes some intuitive sense, but lets think about this logically for a bit. What reasons might I as an investor have for buying more or less than the 1/N-th of my account value in a new investment (where N is the number of stocks I will hold after the purchase)? Presumably that kind of decision would be based mostly off of some risk vs. reward that is a factor in my investment goals.

Buying a higher percent would seem to imply that I believe that stock is likely to return greater rewards relative to the risk. Buying less seems to suggest less reward relative to the risk. Most likely this under-weighting would occur when I think a stock is at the high end of my risk scale, but has potential rewards to compensate, while still falling well shy of the bar that I would call "gambling" as opposed to investing. Whereas I would probably overweight when I believe the potential returns will be greater than what I'm looking for, with average or lower than average risk.

So fast forward from the point I make these initial investments that are more or less equal shares of the port. If one or two of these stocks has preformed very well and now dominates my account value, what am I supposed to do?

I submit that nothing is the correct action most of the time! Or, nothing different than what I always do. I'm always on the lookout for new stocks. If I find something that I believe fits my ports goals better than my average holding, I want to consider purchasing it. In order to avoid full-time money/portfolio management, this will typically dictate that I sell something. (and because I probably don't have unlimited capitol to keep investing)

What to sell?

My first choice is to sell something that experience is showing me I was wrong about. Maybe the risk is higher than I realized. Maybe the rewards are less than I expected. This doesn't have to be my worst performing stock (although that seems more likely than it being my best performing stock).

So I'm actually saying that the percentage of my port that one stock has grown to occupy is simply not an issue. As long as that stock is above average in terms of my reward vs. risk for my port, it's not the stock I'm interested in selling from in order to fund a new purchase.

If a dominate stock or two are the best sources of money for a purchase I want to make, I would only sell a portion of them, because I only want to buy those stocks in proportion to my entire port.

  "If a dominate stock or two are the best sources of money for a purchase I want to make, I would only sell a portion of them, because I only want to buy those stocks in proportion to my entire port."

Now about the Rule Breaker Port... Chances are there are some companies out there that offer the type of rewards and risks that the port is looking for. And if we can find some, then it seems pretty obvious that dropping the stocks that were just dropped makes sense, but that we probably want some more money to invest if we've got a few good stocks. It seems likely that there are one or two stocks out there that hold better potential rewards for the risk than AOL and AMZN. Of the remaining smaller possitions in the port, they (hopefully) continue to hold great reward for risk potential (thus keeping them and selling some of AMZN & AOL).

But again, I'd only sell as much of those as I am able to find candidates that I think are better to put the money into, and I'd surely not want to move all of the money from one of them into one other stock.

This is just my opinion on this interesting debate, but my suspicion is that this is one of the key Foolish practices that lead to long term trouncing of the market as a whole.


[Note: I actually did recently buy about 13% of my port value in AMZN, and it is already becoming seriously overweighted; if I had not bought when I did, I would still consider buying, but again, no more than about 1/N-th of my port value]

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