Position Sizing: What It Is and How It’s Done
Karim Rahemtulla recently released a video on the importance of position sizing. And if you don’t know what position sizing is, don’t worry, you will by the time you finish the video.
Karim considers position sizing the most important concept in investing. Even more important than the concept of the limit order. You may think you understand position sizing, but there may be more to it than you know.
Check out the video below to get a full understanding of what position sizing is. If you can’t watch the video right now, just keep reading and I’ll describe the process as well.
The Dangers of Not Position Sizing
Let’s say you have a portfolio that’s worth $100,000. A stock then comes along that you hear about and you love. Maybe you think to yourself, “This stock is amazing, I’m going to put all $100,000 in it!”
Your spouse may not be pleased with this idea. In fact, he or she may claim that you could lose all your money by doing this. But you insist, “This stock is a winner. We can’t lose!”
Karim rightly points out that your spouse is right. You could lose it all. It’s happened before. You might remember the “great buy” companies Enron and Worldcom… if you do, it’s likely not for good press.
Some people definitely lost all of their money holding those stocks. In fact, some investors lost even more than that because they bought on margin. Had those investors exercised position sizing, they could have avoided those severe consequences.
How Much Is the Right Position Size?
In order to position size properly, according to Karim, you should put no more than 4% of your portfolio in any one position.
Why 4%? Well, it may not be a magic number, but it is a number that’s worked very well for Karim.
If you have a $100,000 portfolio and put 4% into each position, that means you can hold up to 25 positions in your portfolio. That’s what we call a well-diversified portfolio – putting all your money into one stock is the opposite of well-diversified.
Of course, if you’re Warren Buffett and you have billions of dollars to invest, you can put billions in one position because you have many more billions to spend on other positions or to hold in cash.
Of course, Warren Buffett likely knows more about the company he’s investing in than other investors, which certainly gives him an advantage. Meanwhile, you and I and Karim Rahemtulla are not Warren Buffett. We need to worry about position sizing.
How Position Sizing Works
So if you invest 4% of your $100,000 portfolio in 25 different stocks, you will have $4,000 in each stock. Then, let’s say you attach a stop-loss order of 25% to each position. That way, if the stock goes down 25%, you sell.
Now, let’s say one of your stocks does drop 25%. You hit your stop-loss order and you exit the position. How much of your money have you lost? Well, 4% of your total portfolio is $4,000. If the stock drops by 25% it is worth $3,000 and you exit there. You’ve only lost 1% of your money, or $1,000.
While this one stock performed badly, your portfolio has only lost 1% and retained 99% of its value. That’s a whole lot better than losing all of your money by only owning one stock, or owning too much of one stock.
As Karim argues, 4% is not a magic number. You can choose to invest a different amount, such as 5% or 8%, in each position. 4% is Karim’s rule of thumb and as I mentioned before, it works quite well for him.
What To Do Now
If you want to learn more about position sizing and other essential investing concepts, I highly encourage you to sign up for Karim’s free daily e-letter Trade of the Day in the signup box below.
Karim, together with his investing partner, Bryan Bottarelli, have a ton of knowledge to share when it comes to both trading stocks and options. They use the concepts they share in the free e-letter each and every day.
Now that you’re armed and ready with the knowledge of how to go about position sizing properly, you can take full advantage of having a well-balanced, well-diversified portfolio, which can help you make as much money as possible without losing it all.
About Brian M. Reiser
Brian M. Reiser has a Bachelor of Science degree in Management with a concentration in finance from the School of Management at Binghamton University.
He also holds a B.A. in philosophy from Columbia University and an M.A. in philosophy from the University of South Florida.
His primary interests at Investment U include personal finance, debt, tech stocks and more.