Position Sizing: The Vital Secret to Success in Stock Investing
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Position Sizing: The Vital Secret to Success in Stock Investing
The Power of Proper Position Sizing in Stock Investing
It's not the size of the dog in the fight, it's the size of the fight in the dog
This famous quote is attributed to Mark Twain, the famous American writer and humorist. It implies that success is not solely determined by physical size or strength, but rather by determination, tenacity, and fighting spirit. In the context of investing, this phrase can be related to the concept of position sizing.
This edition explores the importance of position sizing and how it can help you achieve your investment goals while managing risk.
Overview
Position sizing is a critical component of successful stock investment. It refers to the amount of capital allocated to a particular investment, and is one of the most important factors in determining overall portfolio performance.
The primary objective of position sizing is to manage risk. No investment is risk-free, and even the most well-researched and promising stocks can turn into a Shitco lose value. If you have been an investor over the past couple of years, you will have no doubt experienced this. Proper position sizing can help manage risk by limiting the potential losses of any individual investment.
One of the most significant risks associated with position sizing is the possibility of overexposure to a particular stock. Investing too much of your portfolio in a single stock can be risky, as any negative news or market downturns can have a significant impact on your overall portfolio performance.
For example, take an investor who allocates 50% of their portfolio to a single stock. If that stock were to experience a 50% decline in value, the overall portfolio would lose 25% of its value. In contrast, if the investor had allocated only 10% of their portfolio to that same stock, the overall portfolio would only lose 5% of its value.
If you were following the discussions on FinTwit during 2020/2021, you would have noticed many investors allocating over 20% of their portfolios to individual growth stocks. While it's easy to see this in hindsight, this approach lacked a crucial element - risk management. As a result, when the market turned sour, some investors experienced significant drawdowns of over 50% in their portfolios.
Here is a tweet from my friend @borninvestor echoing a similar sentiment.
I like to view position sizing as a safeguard against being wrong. Investing involves a lot of assumptions about the future, and even if you've done your due diligence, you can (and will) still get things wrong.
How to Determine the Right Position Size
Determining the right position size for each investment requires consideration of a variety of factors. Here are some steps that you can take to determine the appropriate position size for your portfolio:
Determine Your Risk Tolerance
The first step in determining your position size is to assess your risk tolerance. What is your ability to tolerate potential losses and your willingness to take risks to achieve higher returns? Be honest with yourself and determine your risk tolerance before investing in the stock market. This can help you to avoid taking on too much risk and experiencing significant losses.
Set Your Investment Strategy
Once you have assessed your risk tolerance, the next step is to set your investment strategy. What are your goals and what do you hope to achieve by investing in the stock market? Your goals will guide your investment decisions and help you determine the appropriate position size. Your risk tolerance and your investment strategy are interlinked. Your investment strategy should determine your risk tolerance and vice versa.
For example, if your investment strategy is to generate regular income from your investments, you may choose to invest in dividend-paying stocks with a lower risk profile. On the other hand, if your investment strategy is to achieve higher capital returns over the long term, you may choose to invest in growth stocks with a higher risk profile.
Determine Your Portfolio Size
The next step is to determine your portfolio size. This refers to the total amount of capital that you plan to invest in the stock market. Your portfolio size will impact your position size, as a larger portfolio size may allow for larger position sizes.
It is essential to diversify your portfolio by investing in a variety of stocks across different sectors and industries. This can help to reduce risk and minimize potential losses. Modern Portfolio Theory developed by Harry Markowitz recommends that investors hold a diversified portfolio of assets to reduce portfolio risk. While the optimal number of stocks in a portfolio can vary depending on an investor's goals and risk tolerance, holding a minimum of 10 stocks is often considered sufficient to achieve diversification and manage portfolio risk.
Calculate Your Position Size
Once you have determined your risk tolerance, investment goals, and portfolio size, the next step is to calculate your position size. This is the amount of capital that you allocate to a particular stock.
There are several methods for calculating position size, including the fixed dollar amount method, the percentage of portfolio method, and the risk-based method.
Fixed Dollar Amount Method involves allocating a predetermined amount of money to a particular investment. For example, an investor may decide to invest €5,000 in a particular stock, regardless of the stock's price or the size of their portfolio.
Percentage of Portfolio Method involves allocating a percentage of the total portfolio to a particular investment. For example, an investor may decide to invest 5% of their total portfolio in a particular stock. This method ensures that the investor's exposure to a particular stock is proportional to the size of their portfolio.
Risk-Based Method involves calculating the amount of money to invest based on the level of risk associated with the investment. This method takes into account factors such as the stock's volatility, the investor's risk tolerance, and the overall market conditions.
The risk-based method is the most complex and sophisticated approach for deciding position sizing.
Monitor Your Positions
Finally, it is important to monitor your positions regularly. This is the key difference between active investing and passive investing (ETFs or Index Funds). If a particular stock is underperforming, it may be necessary to reduce your position size or sell the stock altogether. On the other hand, if a stock is outperforming, it may be appropriate to increase your position size.
Dollar Cost Averaging and Position Sizing
Dollar cost averaging can have a significant impact on position sizing. For example, you decide to implement a maximum position size of 5%. Let's say you opened a 3% position in a stock, and it subsequently drops by 40%. At that point, you have the opportunity to add another 2% to your position at the current value.
On the other hand, if the stock shoots up 50% and you already have a 4% position, you may want to avoid getting carried away by the excitement and instead add just 1% to reach the target allocation of 5%. This way, you can stick to their position sizing strategy and avoid making impulsive decisions based on short-term market movements.
Conclusion
While it may be tempting to invest a large portion of your portfolio into a single stock with the hope of earning big returns, it's not just about the size of your investment, but the strength and resilience of your investment strategy. Just like a small dog with a lot of fight can take down a larger opponent, a well-thought-out investment strategy with proper position sizing can lead to success in the stock market.
I have had a number of great discussions with @borninvestor on position sizing and the analogy he discussed (that I have paraphrased) is worth sharing:
Outperformance can easily occur even with 3% positions. For example, if you have 33 such small investments, and 32 go to zero while one goes up 100 times, you will triple your money. It's important to understand that the amount of bullets you have, or the number of shots you take, can make a huge difference in your investment results. Investing in just a few highly correlated companies with large positions can increase the risk of losing everything if the investment goes sour.
The research paper titled Do Stocks Outperform Treasury Bills? by Hendrik Bessembinder adds scientific support to this analogy. The study finds that while the average returns of stocks are much higher than those of treasury bills, the majority of individual stocks underperform treasury bills, and the difference in returns is driven by a small number of exceptional performers.
When it comes to position sizing, my personal preference is to allocate based on a fixed cost percentage of the portfolio. This can result in a stock making up 5% of the portfolio on a cost basis, but 10% on a market value basis. Sizing based on a market value percentage of the portfolio could result in selling half of the stock, even if there is no fundamental reason to do so, and incurring a possible tax liability.
Every stock I buy is with the intention of it appreciating in value, so it doesn't make sense to me to punish it for doing so. Instead, I manage risk based on the initial investment allocation, which means that the maximum loss can only be the amount initially invested.
All of this is from the perspective of a long-term investor. Of course, if you're a trader or a momentum investor, your approach to sizing up positions and mitigating risk may differ from what's being discussed here.
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Happy investing,
Wolf of Harcourt Street
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Twitter: @wolfofharcourt
Email: wolfofharcourtstreet@gmail.com
Position Sizing: The Vital Secret to Success in Stock Investing
Great insights into portfolio strategy!