Why every investor must understand Position Sizing

Jan 31, 2023

Position sizing is the term given to determine the size of your investment or trade. If your exposure is too little, it won't yield respectable returns. If you are overexposed, your portfolio could blow up. It is the bedrock of good risk management as it ensures that your winners count, and your losers don't throw you out of the game.

Rajiv Mehta, Founder of Xtended Business Reporting Ltd, explains in detail why Position Sizing is important and how to approach it.

Diversified vs. Concentrated portfolios. 

A diversified portfolio is one where you don't put all your eggs in one basket. You take small-sized trades and put them in several different stocks. On the other hand, a concentrated portfolio is where you invest most of your money in a lesser number of stocks.

A diversified portfolio will reduce the risk of significant loss with less volatility. On the flip side, the returns will be more muted because even if a few stocks do very well, the allocation to those being small might turn into something other than extraordinary returns.

On the other hand, concentrated portfolios can be very volatile but have massive potential if you get them right. Rakesh Jhunjhunwala's famed bet on Titan is a case in point.

I am biased towards a concentrated approach because I believe that it is the way to create wealth. This wealth is then protected through diversification.

Having said that, it is not a recommendation. To each their own. The route you choose will have much to do with your personality, risk capability, and risk perception.

Whatever portfolio you settle down with, be it 15 stocks or 30 stocks, you will have to decide upon position sizing. There are many options.

Position Sizing: How to approach it. 

Let's say you have Rs 10 lakh to invest. You have researched Company A and would like to purchase it. Its stock is valued at Rs 1,000. Do you buy 1,000 shares or 100 shares? If you spend your entire account balance and buy 1,000 shares, you will have a 100% commitment to this stock. And that's not advisable. There is also the opportunity cost involved.

Remember Seth Klarman’s wisdom: "do not bet the ranch on any single investment."

Alternatively, you can divide the total amount you want to invest by the number of selected stocks and invest the same amount in each company. But there may be a better way to deal with it.

Let me share Klarman's views again.

If your conviction is based on solid research, you should be able to tell a good investment from a bad and a great investment from a good. If one can do so, there is no logic in having the same size position with your best and your hundredth best ideas. Yet, a 20% position is absurdly concentrated, while a 1% position needs to be more significant to take advantage of.

How does Klarman tackle this? He allocates 3%, 5%, and 6% positions to his favourite ideas. This is not written in stone. It could go higher when a cheap position becomes a superb bargain or when there's a catalyst to realize the underlying value.

On the rare occasion when he takes a 10% position, he would do so only if they had a seat on the board to ensure some control, and where there was a chance of a high return.

So, position sizing can be based on the size of an overall portfolio. This means a percentage of that overall capital will be predetermined per trade and will not be exceeded. That could be 1% or even 5%. This fixed percentage is an easy way to know how much you buy when you buy.

Let's revisit the amount of Rs 10 lakh and the stock of Company A going at Rs 1,000. A 1% position will buy you ten shares. You may think you are no better off than someone with Rs 1,000 who buys one share. The difference is that the latter has a 100% position size while you have a 1% position size.

A 1% hard limit on each trade allows you to tolerate many losses in search of profits. One can tweak this as per their risk tolerance.

Mohnish Pabrai used to have a 10-position policy (each position at 10%). His equal weightage reasoning was based on the fact that estimating the probabilities and the odds (the gain if you win) is error-prone, and his own experience was that the bottom three to four bets often outperformed the ones he felt the best about.

He later changed his view because it is also difficult to recover from a mistake if all are weighted equally (in the 2008 mortgage crisis, his bet on Delta Financial Corp (DFC) got killed). Since then, most positions are 2-3% (basket trade) or 5% (baseline) of the portfolio, and if the seven moons line up, 10% (home run).

(Basket trade: buy a basket of companies with small weightings when the risk is slightly elevated.)

Position Sizing: Why you need it. 

Position sizing can determine whether you can be slaughtered by short-term fluctuations or stick around for the long run.

Protecting your capital is your primary job. Your secondary job is allowing room in your portfolio to find other opportunities. Hence, position sizing is about allocating risk, not allocating money.

As James Dinan says, "your position size is more a function of not how much you can make, but how much you can lose. Manage your positionbased on your downward loss perspective, not your upward potential."

That's the key to understanding position sizing. Hence it is better to redefine position sizing along the lines of: how many shares can I buy of a particular scrip within the defined risk?

Should you invest the same amount in a volatile stock as in a company with a stable share price? Probably not. Think of an investment in RIL or ITC compared to a small cap or even a mid cap. A 10% position might be perfectly okay for a large cap, while a 3% position in a high-flying micro cap with frequent 30% swings might be too risky.

Hence, your decision should not be driven by the gains you can make from an investment but rather by how much you are ready to lose if your bet goes wrong. In most cases, the maximum would come in from the bet where you expect the lowest drawdown if adequately researched and worked upon. Your most significant positions should be your high-conviction bets, with the lowest likelihood of permanent capital loss.

Ken Griffin also reminds us of the emotional benefit. "When emotionally married to an investment, we lose the judgment and rationality that defines successful investors. So, I want no position to be so significant in the portfolio that we are emotionally invested in the outcome. It's keeping that objective judgment is so important to our success."

We may develop an emotional connect with an investment. That is why position sizing is so necessary. The Percent Risk Method takes some of the emotional influence out of the process by forcing you to make smaller "bets" when the market dictates and forcing you to make sequentially equivalent bets on each trade.

Limit your size in any position so that fear does not become the prevailing instinct guiding your judgment.

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