Position sizing is something that’s discussed more in the trading world, but it’s just as important for the long term investor. Investors like to talk about diversification, and how holding 15- 20 stocks seems to be optimal for outperformance. However, an investor using a dollar cost averaging strategy may run into issues if they don’t know how to combine this with a prudent position size strategy.
In this blog post I’ll describe some of the issues that can arise when you combine dollar cost averaging with a position size strategy that both keeps you in stocks that are undervalued and allow you to capitalize on better opportunities– which aren’t always available depending on how a stock price (or prices) has moved.
First, let’s define position sizes as it relates to diversification.
The way you define position sizing is usually in percentages. A portfolio starts at 100%. From there, you want to allocate your capital to various investments.
Like the adage “don’t put all of your eggs in one basket”, you want to allocate your capital in a way where you don’t have “unsystematic risk”. Unsystematic risk is the risk of a stock you are holding crashing to a level where you lose a lot of money.
The fact is, you can’t prevent any one stock from losing a lot. It’s part of investing in the market. What you can do is prevent any one big loser from hurting your overall portfolio performance in a major way. The way to do this is through diversification, but proper diversification requires a good position size approach.
How to Calculate Position Size
Going back to allocating individual investments, say that you have $1,000. If you buy $AAPL with $500 and $GOOGL with your other $500, you now have 50% of your portfolio in $AAPL and 50% in $GOOGL. Those are your position sizes. If you put $250 into 4 stocks, you have a 25% position size in each of the 4 stocks. The specific way to calculate position sizing is:
Position size = $$ invested / $$ of Total Portfolio
So again if you have $250 in $AAPL with a $1,000 portfolio, your position size for $AAPL is $250 / $1,000 = 25%.
Now, as a long term investor, you want to shoot for a position size of around 5-10% for each of your stocks. The reason why these numbers tend to be the preferred range is because historically, 15- 20 stocks have been proven to be one of the most optimal ways to diversify a long term, buy and hold portfolio. If you use the math above to calculate 15- 20 stocks over a full portfolio, you get about 5- 6.7%. [click to continue…]