Risk management needs strict rules. To limit potential harm from our emotions, errors and bad luck, the introduction and adherence to specific position limits and execution rules are very important. I am going to discuss some rules you might find useful below …
This is a follow up after my post about averaging down.
Position sizing is a topic I thought a lot about for a few months now. One position grew a bit bigger than I feld truely comfortable with during current macro conditions and perceived risks (second wave of pandemic and related lockdowns). I will reference to the position further down, but I will start to discuss the topic in general first.
I decided it is time for me to (i) think more deeply about my position sizing and to (ii) conceptualise some general portfolio rules as well as to (iii) define some specific rules for myself. I hope you will learn some valuable insights below … (surely I did while writing this post)
The Right Size?
What is the right size for each of your portfolio positions? is the questions I want to answer eventually. I find it useful to think of a standard position size being defined by mine (your) portfolio value over the total number of your positions. So the first question becomes …
How many Portfolio Positions?
Everybody feels different about how many positions to include in his investment portfolio. So there is no one answer that fits all individual investors. But in general we should be aware of the effects of diversification.
More positions increase diversification and lower risk (however that may be defined). But diversification is a two edged sword. Having more positions in your portfolio decreases the role of (bad) luck and we can think about it as an insurance against unforseen bad events. In an extreme scenario you could buy every listed stock and settle for market returns with a maximum of diversification.
We want to outperform the market thus we do not buy every stock. As with insurance, diversification is not free (for value investors). It costs us (precious) time and money to manage more positions and it dilutes our (hoped for) edge on our very best ideas.
Only buying one stock, ideally being our very best idea would be the other extreme, maximizing the expected (risk adjusted) return but it would be far too risky for most of us (it certainly is for me). Considered realistically, our edge might be rather small (that is in the best case that we even have one). Imagine our very best idea was Wirecard. Thus, we have to reduce risk.
The sweet spot might be ~25 positions in our portfolio. Beyond that, adding more securities hardly loweres portfolio risk* any further, but induces more costs, according to academic research. If we hold equity positions in 25 companies, each worth the same market value, a total loss (think of Wirecard) would cost us -4% of our total equity portfolio. This would not be too dramatic for me! If it is for you, I suggest you stop investing in single equities.
*) Even defining risk as the possibility of permanent loss of capital (instead of price volatility), the academic approach provides valuable basic insgihts, I believe.
The topic is well discussed in the post How many stocks should you own in your portfolio? which I strongly recommend to read more.
Let me summarize the learnings so far, referencing to the eggs pictured above: If you only put the two most beautiful eggs (security positions) in your shopping basket (portfolio), and one breaks on your way home (to retirement) your loss can turn out to be catastrophic: You might not have enough eggs for the cake (capital for enjoying your retirement). It is safer to buy some more eggs. So it is better to add the third, fourth and fifths most beautiful egg to your shopping basket …
A standard position size an individual investor could aim for is 4% of the current portfolio value (including dry cash for future investments), based on 25 portfolio positions.
Adjustments For …
Not each position is the same. That is why I believe it is very reasonable to aim for a final position that is above (below) the standard sizing if the proposition is above (below) average. Below I list some features that could lead to a target size above (below) the default position size
- higher (lower) discount to estimated fair value, or potential return
- lower (higher) overall-risk
- low (high) exposure to certain risk factor(s), good match with current portfolio
- higher (lower) quality business, or conviction
- later (earlier) stage in the research process
Are there no limits for the maximum position size if an investment opportunity (or proposition) scores very high on the above bullet points? The answer is a clear no! Even our best ideas have to be kept within certain limits, as we can never know what the future will unfold (again: think about Wirecard). When sitting at the poker table and holding nuts (a non-beatable hand), we want everybody to go all in, including ourselves to maximise the pot and our profits. In the investment world, there is not one investment that comes close to be
nuts a superior investment without the risk of loss. Additionally, there may be hidden risk(s) we are not aware of when having found an investment opportunity with high business quality and high conviction. Like in poker, we could just oversee the fact, that we do not hold the best hand (read more about propositions and poker in my post Striking Similarities between Gambling and Investing!)
The sky is not the limit. No matter how high our conviction in any position might be, there must be a maximum position limit — even if the potential investment scores very favorable on all above listed metrics. A maximum limit could be defined as a certain multiple of the standard position size (i.e. 3.0x). If we take the standard 4% from above, this would result in an upper limit of 12%, which is one 8th of the portfolio value. One 8th of a portfolio is significant and should never be risked (put into one position) without very careful consideration. Now we have thought about adjustments for above average investment opportunities, allowing for higher portfolio weights, but …
If a position outperforms the portfolio and its relative weighting increases accordingly, it might make sense to allow such a position to drift above target weights even more before trimming back. This way a positive momentum might be captured.
Stage of Life
Considering your individual situation is not unreasonable when deciding about your portfolio construction and thinking/implementing rules for your poistion limits. Depending on our current age, stage in life and level of annual net-savings we could allow for deviations from the above rules.
If you are young, frequently contribute a high amount of money relative to your current portfolios market value, you could allow for even higher weights than above, since (above) low relative weights would render the absolute investment amount too small. Additionally, you can easily make up for negative outcomes with adding fresh money to your portfolio (high net savings).
To the contrary, if you are enjoying your late life as a pensioner, it can be reasonable to focus even more on diversification (lower position weights) and risk minmization — assuming you will not add any net savings to but withdraw capital from your portfolio and you want to prevent meaningful losses).
Point of Reference?
It’s not (only) about market values! Besides determining maximum position weightings on the basis of current market values, it is also important to take into consideration the total capital invested in one position and the portfolio. Capping that amount to an absolute value per position before purchasing shares might make perfect sense. Otherwise, you could pour more and more money in a losing position with a performance worse than your portfolio since the relative current value would decrease yet again. Imagine, you purchase more and more shares at even lower prices, with the price approaching zero (as described in my prior post about averaging down, which I also recommend to you, since you seem interested making it so far 😉 )
Timing is a bitch is a regularly used expression by investors (i.e. these two guys), if they miss the perfect time to buy into a stock… but I just wanted to use it to start this section. I believe there is a third dimension that needs to be kept in check besides the (i) relative poisiton size based on current market values and the (ii) total money invested. That is the timing of our purchases or more specific the time between our purchases. To some extend, this is related to the stage of our research. But it might be helpful to implement rules of minimum time periods between trade executions. This way, we can resist to buy into a stock again too early when believing we arrived at our final research stage.
Time between purchases is important, since it enables us to discover underlying business problems we had not seen before or discounted their relevance. For example, cheap stocks might be cheap for a reason (they mostly are) that other market participants deem to be relevant. Time could open our eyes and change our mind. At Bronte Capital they seem to be allowed to increase portfolio positions’ weightings after certain holding periods
[…] every six to nine months I get another percentage point to add. […] the idea is that the easiest way to find out whether you are wrong is to wait. After a year or two the underlying problem will usually become public. If time has not revealed new information then we are allowed to risk more.Bronte Capital – When do you average down?
Specific Rules for Myself
I want to own ~20 positions within my portfolio with a strong focus (and concentration) on researched poistions with a higher weighting (regarding market values and invested capital).
The resulting standard position size is 5% based on market values.
For the time being, I will define the maximum position size as 20% or four times the standard, since the number of my researched companies is still quite limited and I frequently contribute new money to my portfolio.
I also set the maximum for capital invested at 20% of total capital contributions to the investment portfolio(s).
For the time being, I will go with staggered rules for executions for one position. Before reaching the standard position size or 5%, I do not adhere to any rules for minimum time periods between share purchases. After reaching a threshold of 5% (10%), I have to wait for a minimum period of 3 (6) months before purchasing more shares.
I hope for a growing portfolio value over a few years, driven by additional contributions and significant performance returns on current investments. When this happens, I am going to adjust the number of portfolio positions upwards and the maximum position sizes downwards.
I have to exit some positions first, before increasing the number of total portfolio positins. Of my current portfolio of 24 positions, only 8 are (partially) researched. They represent almost 50% of my total portfolio value (incl. cash). On the contrary, my smallest six portfolio positions account for less than 5%, and I plan to trim some of them.
Real Life Examples
As promised above, I am going to discuss two real life examples:
I trimmed my position in Pandora A/S (articles) recently because (i) a rebound in Pandoras share price increased its market value and (ii) decreased the discount to my last fair value estimate (but is still high though), my (iii) conviction was lower than at the beginning of the year and (iv) the company has a high exposure to the pandemic.
My highest conviction position so far is Check Point (articles) and in general I would like to buy more shares. But I invested a lot of money already and struggled to come to a conclusion if to allow myself to buy even more shares. Now that I have established the above rules for myself, it becomes a lot easier for me to act on that matter.
I hope you learned some interesting and helpful concepts. I did for sure.