How Much to Invest?

💹 StableBread’s Automated Stock Analysis Spreadsheet now offers a free version!

You can sign up to Wisesheets for free to start using the model (only AMZN, TSLA, and AAPL), or upgrade for only $60/year to access all stocks.

This spreadsheet will help you analyze more stocks and make quicker, more informed investment decisions, while avoiding the time-consuming task of building custom models or manually copy-pasting data.

🌾 Welcome to StableBread’s Newsletter!

After screening, analyzing, and valuing a business, you may arrive at the decision to buy the stock.

The question then becomes: how much of your portfolio should you allocate to this position?

This is what Joe Ponzio addresses in his book "F Wall Street" (2010).

His answer is simple and intuitive. The amount you invest should match your confidence in the business. Great companies at deep discounts deserve meaningful allocations. Speculative bets on unproven businesses deserve tiny ones.

The challenge is defining "confidence" objectively, so you avoid being either over-concentrated or over-diversified in your portfolio. This post explains Ponzio's framework for solving this exact problem.

Ponzio's position sizing approach centers on this concept:

This isn’t a mathematical formula. It’s a framework for thinking about how much to invest in each position:

The logic is intuitive. Companies with predictable cash flows and dominant market positions deserve meaningful allocations. Speculative businesses with uncertain futures warrant only small bets.

For example, if you estimate Coca-Cola’s (KO) stock price at 30% of intrinsic value, you might allocate 15% of your portfolio. But for an unproven biotech startup, you'd limit your position to just 2% due to lower confidence.

To make this approach practical, Ponzio categorizes all companies into three groups based on their size and competitive position. Each category has specific allocation limits and margin of safety requirements that reflect the inherent risks…

Industry leaders (market cap > $10B) are the giants that dominate their sectors and generate massive cash flows year after year. Think Microsoft (MSFT) in software or Johnson & Johnson ( JNJ) in healthcare.

These companies have proven their business model and maintain their positions through scale advantages that make it difficult for competitors to challenge them. While their size makes explosive growth unlikely, it also provides stability and predictability.

Ponzio recommends allocating 10-25% of your portfolio to each industry leader you purchase. In exceptional cases, when you find a deep discount combined with strong growth prospects, you might consider up to 40% in a single position.

Why such large allocations? Because finding a best-in-class company at a substantial discount represents a rare opportunity.

Ponzio's required margin of safety is just 25%. A $100B company trading at $75B still offers attractive returns with limited downside.

You can monitor these positions annually. Industry leaders move slowly and somewhat predictably, so their fundamental business rarely changes quarter to quarter.

Middlers ($1B - $10B market cap) are well-known within their industries and have significant growth potential, but face pressure from both directions.

These companies must either grow large enough to challenge industry leaders or risk being overtaken by smaller, hungrier competitors. They can't maintain their middle position indefinitely, because someone will eventually pass them in one direction or the other.

This uncertainty drives Ponzio's more conservative approach. He limits each middler position to a maximum of 10% of your portfolio. While you want exposure to their growth potential, you need protection from execution risk.

The required margin of safety doubles to 50% for middlers. If you value a company at $2B, you shouldn't pay more than $1B. This larger discount compensates for the additional risks these companies face.

Unlike industry leaders that you can check annually, middlers require quarterly monitoring. These companies can change course more rapidly than industry leaders, and both positive and negative developments materialize faster.

Small companies (< $1B market cap) represent the most fragile investments in the public markets. Their size makes them vulnerable to individual events that larger companies wouldn't even notice.

Ponzio elaborates on this vulnerability:

This fragility demands careful position sizing. Ponzio limits small fish positions to 5% of your portfolio at most, ensuring that even a total loss won't significantly damage your overall returns.

The margin of safety remains at 50% minimum, though 70-80% provides better protection against the numerous risks these companies face.

Small fish require intensive monitoring. You need to read every SEC filing as it's released, recalculate valuations quarterly, and monitor stock prices regularly.

Given all these challenges, why invest in small companies at all? Because a small company purchased at a significant discount can generate 10-100x+ returns if they manage to execute and grow market share.

The key is recognizing the risks through proper position sizing, so a failure won't devastate your portfolio.

Ponzio illustrates proper diversification through small business failure rates. Most small businesses fail within their first year. Of the survivors, most fail before year five, despite some generating millions in revenue.

The investing parallel is clear:

This logic explains Ponzio's allocation limits. Invest 3% in a small fish and you risk little. Invest 30% and you're gambling your financial security for, as Ponzio notes, "a few extra dollars."

Ponzio explains how margin of safety mathematically protects your portfolio even when you're wrong.

Let's say you purchase ten stocks, each worth $10,000 in intrinsic value, but you pay only $5,000 for each due to a 50% margin of safety. Your total investment is $50,000 for $100,000 worth of businesses.

Three years later, assume half your picks fail completely while the other half reach their intrinsic value.

If the intrinsic value of each winner grew 8% annually, it would increase from $10,000 to $12,597 ($10,000 × 1.08³). Since these stocks now trade at their intrinsic value, you'd have five positions worth $12,597 each, totaling $62,985.

Despite a 50% failure rate, you still achieve an 8% annual return on your original $50,000 investment.

This is why demanding steep discounts from riskier companies works. The margin of safety ensures that even with multiple failures, your winners can carry the entire portfolio to your target returns.

When Ponzio refers to portfolio percentages, he means specifically at the time of purchase. If you invest $10,000 representing 20% of your $50,000 portfolio, that calculation happens when you buy.

Over time, your investment allocations will naturally shift due to varying performance across positions.

A successful position that doubles while others remain flat will grow to represent a larger portion of your portfolio. This reflects the natural result of winners outperforming, not a problem requiring action.

So, when should you consider selling a winner? Never sell a successful business simply because it has grown large. Only consider selling if the price exceeds intrinsic value or the business fundamentals deteriorate.

The inverse also holds true. If a position declines below your target allocation and the investment thesis remains intact, consider adding more. A great company at a significant discount becomes an even better investment at a larger discount.

For beginning investors with ~$5,000 saved, concentrating in a single industry leader at a deep discount is logical.

Since you're actively adding savings each month, that single concentrated position will naturally become a smaller percentage of your total portfolio over time as you make additional investments.

Larger portfolios require different approaches. A $100,000 portfolio with no new savings coming in should cap any single position at 40% maximum, and only for truly exceptional opportunities.

Even $5M portfolios don't benefit from excessive diversification. Ten positions of $500,000 each work well. Adding mediocre investments purely for diversification dilutes your best ideas and increases risk.

Ponzio warns that the entire framework collapses without discipline. If you estimate a business worth $100 and demand a 50% margin of safety, never pay $51. Not even for your favorite company.

Ponzio emphasizes this point:

With a 25% margin of safety on industry leaders, you need to be right three out of four times. This requires holding at least 4-5 positions. If you held just one and it failed, you'd lose everything.

With small fish requiring up to 80% margins of safety, you need 15-20 positions to compensate for the higher expected failure rate.

The margin of safety and position sizing work together to create a portfolio that can withstand inevitable mistakes while still achieving your goals.