Position Sizing in Value Investing

Benjamin Graham — Warren Buffett's mentor — gave very specific instructions on capital distribution across grades of stocks within a portfolio.

Optimum Diversification

Both Warren Buffett and his mentor Benjamin Graham — the founder of Value Investing — have described the pros and cons of Diversification in great detail.

Graham therefore gave some very specific instructions on the subject of Position Sizing across various grades of stocks.

Graham Grades

a. Defensive

Graham recommended a minimum portfolio size of 10 for Defensive grade stocks; or in other words, not more than 10% of one's portfolio per Defensive grade stock.

"A minimum of ten different issues and a maximum of about thirty."
Chapter 5: The Defensive Investor and Common Stocks, The Intelligent Investor

b. Enterprising

In keeping with the same principle, Serenity recommends a portfolio size of 20 for Enterprising grade stocks; or in other words, not more than 5% of one's portfolio per Enterprising grade stock.

This is due to the fact that Enterprising grade stocks have fewer qualitative requirements than Defensive grade stocks, but more than NCAV (Net-Net) grade stocks.

Here's what Graham himself wrote for this category:

"If our winnowing approach had been applied to all 4,500 companies in the Stock Guide, and if the ratio for the first tenth had held good throughout, we would end up with about 150 companies meeting all six of our criteria of selection. The enterprising investor would then be able to follow his judgment—or his partialities and prejudices—in making a third selection of, say, one out of five in this ample list."
Chapter 15: Stock Selection for the Enterprising Investor, The Intelligent Investor

c. NCAV (Net-Net)

Graham also recommended a portfolio size of 30 for NCAV (Net-Net) grade stocks; or in other words, not more than 3.3% of one's portfolio per NCAV (Net-Net) grade stock.

"30 issues at a price less than their net-current-asset value."
Chapter 15: Stock Selection for the Enterprising Investor, The Intelligent Investor

An Example

As an example, one could distribute 100% of one's capital across:

  • Five Defensive grade stocks (5 x 10% = 50%), plus
  • Six Enterprising grade stocks (6 x 5% = 30%), plus
  • Six NCAV (Net-Net) grade stocks (6 x 3.3% = 20%)

Graham also gave detailed instructions on capital distribution across equity and debt.

Comments

I think graham doesn't recommended mixing strategies.
However i read he does not recommend investing more than x% in high risk capital.

Dear pipo2152,

Thank you for your comment!

While Graham does draw clear distinctions between Defensive and Enterprising investors, he does not restrict Enterprising investors from also investing in Defensive grade stocks. In fact, NCAV grade stocks are specifically recommended for Enterprising investors.

The statistical work of finding Enterprising and NCAV grade stocks is also possibly much easier for the average investor today, than it was in Graham's day; because of services such as Serenity. But yes, it should be understood that anyone investing in Enterprising or NCAV grade stocks is an Enterprising investor; by definition.

Keeping the above in mind, it seems only logical to interpret "a minimum of ten Defensive grade stocks" to "a maximum of 10% of funds per Defensive grade stock"; and so on. Graham does not advise against doing so, and doing so does not violate the principles of diversification that such recommendations are based on.

Regarding speculation, Graham does say that if one must do so, one should put aside a portion (preferably small) of one's fund for it.

Thank you again for your comment!

You are an excellent professional.

Benjamin Graham recommends not investing less than 25% in bonds. But it also talks about index funds and Reit's. We can replace a bond etf with an index fund?

Thank you so much for your answer Serenity. Sometimes, I have difficulty interpreting English.

Dear pipo2152,

Thank you for kind words!

Since the idea is to distribute capital across Equity and Debt, a debt-based Index Fund should work just as well as a Bond ETF. Please note that REITs don't appear to score too well on the Graham framework.

Thank you again for your comment! It's great to have you on Serenity.

Graham Resources