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%.
The obvious caveat here is that I mentioned a 5- 10% range when the math indicates a 5- 6.7% range on positions that are evenly distributed exactly. This is a personal belief of mine, but I believe that it’s okay to weight certain stocks higher than others if you have more conviction on their future performance. Conviction on future performance should include solid fundamental analysis characteristics such as a strong balance sheet, profitability and/or fantastic valuations.
I’m also not alone in this type of thinking. Many investors such as Warren Buffett and Charlie Munger have seen success with a more concentrated (aka focus) portfolio, and Buffett has even had a single stock such as GEICO make up over 40% of his portfolio at times.
While 40% seems really extreme even to me, I think the upper range of 5- 10% is flexible and is really subjective for each investor.
It’s a personal decision and depends on how much risk an investor is willing to take on, how confident an investor is in both his own skills of identifying great opportunities and his personal feelings on a company, and his ability to remain rational and really hold for the long term to allow a stock to recover to its true intrinsic value even when the market disagrees for what can be a long time period.
Issues w/ Dollar Cost Averaging and Position Sizing
Perhaps the biggest potential problem and something most overlooked by the average investor is the impact that dollar cost averaging has to an investor looking to manage their own portfolio. You don’t see this discussed hardly at all by even the best investors, primarily because most of them don’t face this issue.
If you think about the way that a hedge fund or mutual fund is structured, the managers really have a base of capital that they need to allocate right out of the gate. There may be additions or subtractions to this capital depending on how many investors enter or exit their fund, but they usually don’t have a consistent flow of incoming capital like the average investor using dollar cost averaging might have.
The impact of dollar cost averaging to a portfolio highly depends on what stage of growth an investor’s portfolio is at.
For example, say an investor is dollar cost averaging $150/ mo, like I frequently recommend as a starting point. The position size of this monthly deposit wildly varies depending on a portfolio’s size.
In the first month of an investor’s dollar cost averaging strategy, putting all of the money into a single stock represents a 100% position size. It isn’t until month 10 that the monthly deposit represents a 10% position size. By month 20, or just under 2 years, each new dollar cost average deposit represents about a 5% position size– which is right at that ideal diversification range that long term investors should be targeting.
An investor may think that they can just fully diversify their dollar cost averaging deposit right away, so that in the first month they simply split the $150 into 20 positions and have a 5% position size throughout the portfolio. There are several problems with this:
- For the average, starting investor, which makes up a majority of my audience, there is no way to split up a small sum such as $150 into 20 individual stocks. Stocks may trade at a range between $10- $100 or more, meaning that $150 might only be able to purchase 1 share
- It’s highly unlikely that you can find 20 great stock opportunities all in one month. To be a great long term investor you need to also make sure that you are buying stocks that are trading at a general discount to their intrinsic value, and unless you are investing amidst the chaos of a bear market, it’s highly unlikely you can find that many deals
- The idea of buying 20 stocks at once is also quite improbable because the purchase of a stock should require a coarse (?) understanding of each business and a base level amount of research. Unless the idea of spending 10 hours a day for a month appeals to you, it doesn’t make sense to try and binge research 20 or more companies just to achieve diversification faster
At the end of the day, investing is a long term process that should be carried for the rest of someone’s life. That means a preferred holding period of many years or decades, and not a outlook of just a few months or even years. Waiting a couple years to achieve your ideal position size strategy and diversification is really not much time at all in the grand scheme of things.
The solution is to simply take your personal dollar cost average deposit and scale into your positions one at a time. That means taking 1 position in month 1, taking your second position in month 2, etc, etc.
Soon enough you’ll achieve your preferred 5% position size and will have built a portfolio that is diversified both from a position size standpoint and somewhat from a time period standpoint. The market may move substantially in just those couple of years, and now you have investments planted during various places of market price levels.
Advanced Position Size Techniques
The next potential problem is what to do as your portfolio is already built and you still need to dollar cost averaging. The solution again requires good position sizing, but the way you will do that varies based on where in the life cycle your portfolio is.
For example, say your portfolio balance is at around $8,000 right now. A new monthly deposit of $150 will only make up a 1.8% position size. You can’t simply buy a new stock each month at this point, because you risk having more than 20+ positions and your portfolio’s performance will start to more closely track the overall market’s performance. At which point, you might as well just buy a total market index ETF rather than pick individual stocks.
Again, this isn’t talked about by the best investors enough. So to find the solution to this problem, let me share exactly what I do with the Real Money Portfolio for The Sather Research eLetter– where I deposit $150 each month into a Roth IRA with a goal of dollar cost averaging for 40 years. As I write this, the portfolio has just hit about $8,000, and so new stock buys don’t hit the 5- 10% position size any longer.
I’ve received specific questions from subscribers about what I mean about position sizing in the eLetter… I’ll highlight one of those questions here and talk about the specific process I use to achieve our desired position size strategy:
Hey Andrew, thanks again for such a set of valuable tools (VTI spreadsheet, newsletters (both free and subscribed, podcasts, blog, and so on).My question as a near total newbie (bought my first stocks last month!!!) is one on portfolio weighting. I’ve done some searches to find out how to calculate this and they all seem to focus on swing trading and not value investing using DCA.So more specifically, how does one calculate position weighting? Even more specifically while building a portfolio that is far from diversified.In your paid newsletter portfolio breakdown it says 1x or 8x, is that just as simple as you’ve purchased one share or 8 shares of that particular stock (as much as $150 worth in dca would allow each month)? Or is it a floating percentage type of thing based on how much has been invested totally being effected by each new stock buy? I’m sure I’m making it much more complicated than need be and very much appreciate any light that can be shed on it. Thanks again!Joshua C.
The way I present my position sizing in the paid eLetter is with a column marked “size”, and various figures defining those sizes: 1x, 4.5x, 8x, etc. What I’m referring to here is not the number of shares I’m buying, but rather how much I’ve invested (or will invest) with regards to my average dollar cost averaging deposit.
Remember that for the eLetter portfolio, I’m investing $150 per month. To achieve a 1x, that means I’m buying $150 worth of that stock ($150 x 1). The 4.5x means I’m buying $675 worth of that stock ($150 x 4.5)… and so on.
Of course the numbers are never exact, as the number of shares you can buy each month with a deposit will depend on where a specific stock’s current share price is at. If a stock is trading at $100, I’ll only be able to buy 1 share with $150. That’s fine, the next month I’ll roll that extra $50 into my next stock buy, and if that month’s stock buy is at say $90, I can buy 2 shares with my $200 instead of 1 share from $150.
Again, it’s not going to be exact and everybody’s specific share count will vary based on how much they are investing and when they started investing, so the position size column is somewhat of an estimate and should just be a goal to get close enough to.
Diversification for a Maturing Portfolio
The next thing to consider is how I’m making specific stock buys now that the portfolio has increased beyond $8,000. At this point I basically need about $400 into each stock to have the positions at a 5% position size. That means each position should be displayed at about a 2x in the eLetter.
But if you’re a subscriber, you know that’s not the case. And the reason behind that is that stock prices move. Many of the stocks I bought at a 1x months and years ago have risen in price to the point where they are no longer good deals to buy for the long term. Their opportunity to “buy low” as passed.
And so what we need to do with a portfolio that has matured to this point is to scale into new positions with the relation to dollar cost averaging and position sizing in mind.
For example, in the past 2 issues of the eLetter I recommended the same stock pick for both months. In a time period of just 2 months it’s unlikely that a stock will increase by so much that it’s no longer a good buy anymore, and so I added to a position I already had– making the “size” column 1x –> 2x –> 3x. At 3x, this stock is at about a 5.6% position size, and I can now focus on getting other positions back to the preferred 5-10% range.
But every month is different, and every month I need to evaluate whether to add to a certain stock or just leave it alone (because its price is too high now). It’s highly dependent on its valuation, AND what the portfolio’s balance is at, AND what the current position size already is.
There may even come a time where I’m forced to carry more than 20 stocks in my portfolio because all of my current positions will be at or above fair value. However, I doubt that I’ll have to worry about over-diversification to the point of tracking to average market performance, and here’s why. If many of my positions drop down to a position size of 2%, 1% or lower, it’s up to me to make sure that on a whole, my portfolio is diversified but not overly so.
You might think that sounds impossible, but consider this. Say that I have 24 stocks instead of 20. But let’s say that 5 of those stocks are each at a 1% position size, and the remaining 19 are at 5% each. That’s still great diverisifcation without being overly diversified. But if you compare that to, let’s say 50 stocks that each have a 2% position size, well you might as well buy a total market index at that point.
So I hope that all makes sense. I know the last half of the blog post has some pretty advanced concepts, but they’re important for the average long term buy and hold investor to consider. I tried to structure the blog post in a way that progresses downwards with the stages that you face when building a portfolio. If anything, this is a blog post you can reference as you pass through the various stages.
Position sizing is extremely important in building and maintaining a portfolio, whether you consider yourself a trader or an investor. Don’t discount the significance of this step in your overall returns, and make sure you have a strategy in place.