In 2008 I spoke at the Value Investing Congress in Pasadena, and I sat next to legendary investor Mohnish Pabrai.

I used this opportunity to ask him a question about diversification and position sizing.

I asked him, "Mohnish, how can you handle a portfolio of just 10 stocks? Doesn't volatility drive you crazy?"

He replied, "Vitaliy, don't look at me. Look at the guy to your left. This guy has only three stocks."

The next day, this guy gives a presentation on the Kelly criterion.

It's a concept from gambling that says that if you see the probablity of winning as much greater than the probability of losing you should place disproportionately large bets.

It's about position sizing.

He argued that if you calculate the Kelly criterion for a stock, it should be a very large portion of your portfolio.

In his view, there is nothing wrong with a three-stock portfolio.

This guy pitched a natural gas stock.

At the time, natural gas prices had dropped from $13 to $8, and he argued they couldn't go below $7.

They declined to $1.50.

His fund completely blew up.

His previous five-year returns of 25% annually turned into a negative 90%.

This story illustrates two crucial points:

1. Surviving is incredibly important.

2. Your strategy has to match your constituency