The Dhandho Investor
Dhandho 301: Few Bets, Big Bets, Infrequent Bets
The basic idea behind this chapter is that when an opportunity exists, it is important to bet big. The author is not an adviser on investing often, with money that won't move much. Instead, he suggests investing disproportionate amounts of money when the odds are clearly in his favour.
To compute how much an investor should bet on a given opportunity, Pabrai recommends using the Kelly Formula. It calculates the optimal fraction of bankroll to bet.
Edge/odds = Fraction of your bankroll you should bet each time
However, a major drawback of using this formula is that it requires knowing the payout amounts and the odds in advance. This information is available in gambling games (where the Kelly Formula is probably more applicable), but stock returns are not computed with so much assurance. To better understand how investors should think about investing in a particular opportunity and why, he proposes William Poundstone's book, Fortune Formula.
Although the motel-buying Patels depicted in earlier chapters of the book may have never heard of the Kelly Formula, Pabrai claims that they still recognize the basic concept behind it and that is why they were so successful: when a great opportunity arises, bet big. Pabrai also evaluates the statements and writings of Charlie Munger and Warren Buffett and concludes that they use the very same credo. Charlie Munger said in a speech at the USC business school:
"The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple."
And Warren Buffett wrote in his partnership letters from 1964 to 1967:
"We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could change the underlying value of the investment."
As a result, Pabrai finds it confusing that the average mutual fund holds 77 positions and the top 10 holdings represent just 25% of assets. Dhandho, on the other hand, as he explains it, is about making small bets, big bets and occasional bets.