How much of our portfolio should we invest in a high conviction stock?
This is an age-old question for any investor. In this article, I touch on two concepts – the absorbing barrier and Kelly criterion – and see how we can use them to structure the way we think about position sizing in investing.
Absorbing barrier
Imagine playing a game of Texas Hold’em poker and being dealt the best starting hand of the game – a pair of aces. This hand has an approximately 80% chance of winning against any other starting-hand combination.
What would be the ideal bet to make here? In theory, the bigger your bet, the bigger your expected return is on the investment because the odds of winning are tilted heavily in your favour. But does this mean we should bet all our savings on this hand? Probably not.
This is where the idea of the absorbing barrier becomes relevant. Nassim Taleb, author of a number of books, including Fooled by Randomness, explains,...