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.
Position sizing becomes less clear when combined with dollar cost averaging (“DCA”). New investors may run into issues if they don’t know how to combine the two.
In this post, we will discuss the 3 key basics to position sizing and managing a portfolio [Click to Skip Ahead]:
- Why Diversification (and Position Sizing) Is Important
- How to Calculate Position Size
- Building a Portfolio, Diversification, and DCA
First, let’s define position sizes as it relates to diversification.
Why Diversification (and Position Sizing) Is Important
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
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 for these numbers is because studies have shown a 15-20 stocks portfolio is sufficient for reducing unsystematic risk.
Note that the studies suggest positions of this size reduce unsystematic risk as defined by volatility, not actual risk (read more about that here).
Building a Portfolio, Diversification, and DCA
Average investors often overlook the implications of diversification while building a 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.
The typical hedge fund or ETF is structured a certain way. Managers have a base of capital that they need to allocate right out of the gate. This amount can fluctuate depending on how many investors are entering or exiting their fund.
Contrast that to the average investor building a portfolio. Good portfolio building means using dollar cost averaging, which means more capital is always coming in.
And this impact highly depends on what stage of growth an investor’s portfolio is at.
Example: Starting from Scratch
For example, say an investor is dollar cost averaging $150/mo. 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 ($150) represents a 100% position size.
Now continue this process, with $150 into a new stock each month.
After month 2, each stock represents a 50% size ($150/$300). It isn’t until month 10 that the monthly deposit represents a 10% position size. Fast forward to month 20. After just under 2 years, each new ($150) deposit finally represents about a 5% position size. This is ideal.
But notice that there was a process to get to ideal position sizing, which took some time to get to. It’s this process that most investors, especially beginners, don’t get.
Why not invest in 5% position sizes all at once?
An investor may think that they can just fully diversify right away, splitting the $150 into 20 positions and have a 5% position size throughout the portfolio. There are several problems with this.
The biggest is that it’s highly unlikely that you can find 20 great stock opportunities all in one month. You want to buy stocks at a discount to intrinsic value (a margin of safety). Unless you are investing amidst the chaos of a bear market, it’s highly unlikely you can find that many deals.
Even if you could, it’s virtually impossible to understand 20 businesses deeply if you are just starting out with investing.
Investing in individual stocks means establishing a circle of competence with what you invest in. In other words, you have to know what you’re buying and why you will hold it for the long term.
It’s just not reasonable to believe you can understand so many businesses in such a short time like 1 month. Taking your time to more deeply research businesses, such as 20 months, will give you the assurance to hold your stocks confidently. That confidence is essential to being successful with a buy and hold strategy.
Investor Takeaway
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 an outlook of just a few months or even years. Waiting a couple years to achieve ideal position sizing is really not much time at all in the grand scheme of things.
The solution is to simply take your personal dollar cost average deposits 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 in two ways. It will be diversified by size and even over different time periods. The market may move substantially over a 20 month period; now you’ll have investments bought at different price levels.
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.
