Position sizing plays key role in portfolio creation

The success of our investment and the wealth created through an investment is determined by the extent of exposure. In investing parlance, this is defined as position sizing which depicts the size of the investment or trade. In general, we tend to look at the return ie, the percentage it generates. Even if one were to end up with a great return over an investment but the quantum of that investment is low then it wouldn’t substantially add to the portfolio.

Also, position size helps in managing the risk as a high concentration towards a non-performing stock or asset would badly impair the entire portfolio performance. So, this metric is critical in not only helping one to achieve better returns but also contain the losses when bet the turns bad. While there’s a constant tussle between concentrated and diversified investing strategies, position size often brings the required balance in-line with the investor’s risk profile.

The age-old adage of “don’t put all eggs in one basket” defines the diversified portfolio and thus reduces the exposure in each stock to a lower level of exposure. On the other extreme, a concentrated portfolio aims at maximizing the returns by having lesser number of stocks. A diversified portfolio reduces the potential of high losses and limits the volatility while also fails to extract maximum potential or gains if the stocks do well.

The volatility is high in a concentrated portfolio and the prospects of outperformance rests solely on the limited possibilities. Tales of big investors are littered with such huge bets on limited number of stocks striking gold for them. The option of exploring either of the strategies is dependent on the investor’s personality, risk capacity and risk tolerance.

Though, concentrated bets appeal from the possibilities of outcomes, it’s fraught with higher risk. Position sizing thus comes to rescue. Seth Klarman famously once said, ‘do not bet the ranch on any single investment’ and thus giving his favor to diversification. The other way to approach position sizing is to provide a minimum percentage allocation to any of the bets one takes. Then as the conviction improves on any of the bets, one could increase the allocation to it. This step-up approach helps in testing one’s own thesis and make incremental allocations as the results bolster the initial logic.

Some investors use an equal weight allocation but if the basket of ideas or trades is limited then it could turn into a concentrated approach. Mohinish Pabrai gave up this approach after a debacle during the Great Financial Crisis (GFC) where he realized it’s difficult to recover from a mistake.

Charlie Munger says that the whole secret of investment is to findplaces where it’s safe and wise to non-diversify. The whole trick of the game is to have a few times when you know that something is better than average and to invest only where you have that extra knowledge. Even his partner, Warren Buffet says explaining Berkshire’s strategy of capital allocation, ‘we put a lot of money in things we feel strongly about. We think diversification, as practiced generally, makes very little sense for anyone that knows what they’re doing. Diversification is a protection against ignorance.

While Buffet takes such an extreme view, he always sticks to his two rules of investing. The first is not to lose money and the second is to not forget the first rule. Position sizing addresses in achieving that first rule.

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

Also, position sizing helps in making investment judgement more rational. It culls the emotion out of the equation and brings stability to the decision making. We tend to get overboard and so sidestep risk tolerance as conviction increases. So, position sizing helps one to add a good risk management tool to the investment philosophy.

(The author is co-founder of “Wealocity”, a wealth management firm and could be reached at [email protected])