Position Sizing: How to Limit Risk and Maximize Gains
by Matthew Weinschenk, Contributing Editor
Wednesday, July 29, 2009: Issue #1053
It’s amazing how some of the basic investment strategies – like position sizing – that underpin our philosophy here at Investment U, can overlap into everyday life, so to speak.
One Saturday, years ago, some friends and I went looking for a fun day out and found ourselves at the horse track. Among our group was a track first-timer, hell bent on maximizing his winnings. He laid a big bet on a 20-1 long shot. And when the horse hit the wire dead last, he’d officially been indoctrinated in horse racing and true speculation.
Forget making money, he’d managed only to maximize his loss.
Ever the competitor, he bet on two more races, wagering on big long shots in each. And in about as much time as it took us to park the car, he was wiped out. While the rest of us, only betting $10 or $20 a race, still had hours of fun ahead.
That was seven years ago. And, to date, my friend still hasn’t found the guts to make his horse-racing comeback. It’s just another instance where fortunes could have changed, for the better, using position sizing – the most under-appreciated decision in investing.
Unfortunately, thousands of investors make the same mistake each and every day.
Here’s how you can avoid treating your investments like random horses and a few rules on how to use position sizing to be sure your money will be around for the long term.
How Position Sizing Works
To illustrate how important position sizing is, let’s look to trading guru and Oxford Club friend, Van K. Tharp. In his book Trade Your Way to Financial Freedom, he develops a trading model and then tests it in five different ways, changing nothing each time but the position-sizing strategy.
Based on an initial investment of $1 million, the worst of the five scenarios returned $32,567 in a year. The best returned $2,109,266 – an incredible difference, based solely on position sizing!
To be fair, Van K. Tharp specializes in short-term trading. So we ought to show how to apply this strategy to our longer-term approach.
Let’s use an extreme example to demonstrate how position sizing relates directly to risk…
- Say an “Average Joe” investor has a starting portfolio of $10,000. And he’s extremely aggressive, putting 50% of his portfolio’s net worth into a single stock. When he sells it (whether for a gain or loss), he again puts half of his portfolio’s worth into his latest stock. And he does this each time, in effect, owning only one stock at a time.
- Now, let’s say his investment strategy performs well, and every position earns 50% that year. Under such premises, after selling all five positions, his portfolio would have swelled to $30,518.
- However, if his strategy had not performed well, and each position fell by 30%, he’d be left with less than $6,000. That’s a high-risk/high-reward approach, for sure.
- Compare that to investor No. 2, who takes a much more conservative approach. He puts 1% of his portfolio into each recommendation. If he encounters precisely the same bad year and each position falls, he’ll still have $9,900 – only taking a nominal loss. However, if he experiences the same success as our first “Joe,” the most he stands to profit is $253 – hardly worth the time of trading.
Position Sizing Strategies & General Rules of Thumb
Of course, a real investor would fall somewhere between the two extremes when following a position sizing strategy.
Here’s a general rule of thumb:
- Limit your investment in any particular stock to 4% of your equity portfolio’s net worth.
- If you want to err on the side of caution, invest less. If your tendency is toward being aggressive, invest more. But not too much more.
- You should also consider the type of stock you’re investing in. For example, you might feel more comfortable having a larger weight in a blue-chip stock.
Over at The White Cap Report, we isolate smaller, speculative companies with breakthrough products. As such, we don’t recommend putting more than 1% in any single stock.
Remember that the stock market, historically speaking, favors the investor. (Conversely, horseracing is rigged in the house’s favor. The track skims enough off the top of each race that it always wins.) Watching your position size will ensure that you’re around long enough to reap the rewards.
Ahead of the tape,