Position sizing is a crucial aspect of successful investing. It involves determining the appropriate amount of capital to allocate to each investment in order to achieve sufficient risk management and maximize returns. In this article, we will explore the importance of position sizing and how it contributes to executing an investment strategy effectively.
The Role of Position Sizing
Position sizing is a key factor of investment strategy, serving as a tool for managing and mitigating various risks inherent in the market. By carefully allocating a specific percentage of your portfolio to each position, you can effectively reduce the impact of both company-specific and market-related risks. This approach not only safeguards your investments but also plays a pivotal role in maximizing returns. Oversizing a position may expose the portfolio to potential catastrophic losses, while under sizing can lead to the risk of subpar performance. Achieving the art of precision sizing entails finding the delicate balance that best suits your objectives, ultimately optimizing your portfolio’s returns.
Systemic Risk
Mitigating systemic risk, which encompasses market-wide or sector-specific vulnerabilities, involves prudent portfolio management strategies. One effective approach is to diversify your portfolio and limit each position to 20% of the total portfolio cost. This prudent allocation shields you from overexposure to any single company or industry, reducing the potential for substantial losses during market downturns or sector-wide crises while concurrently maximizing potential returns.
To further fortify your defenses against systemic risk, it is essential to consider the industries and sectors in which you invest. Given that systemic risk transcends individual companies and can affect entire sectors, it’s crucial to avoid excessive concentration in one area. For instance, an overly tech-heavy portfolio could be vulnerable to adverse events in the technology sector. Similarly, over-concentration in sectors like healthcare, energy, or financials carries its own risks. To safeguard against regional and exchange risk, diversify across different regions and industries, as well as individual businesses. This strategic diversification approach effectively manages systemic risk without the need for excessive over-diversification.
Temporal diversification, or averaging into positions, serves as a strategy to mitigate systemic risk. This patient method involves making a series of purchases over a defined period, capitalizing on the price fluctuations of shares. It’s a nuanced way of building into or out of positions, especially when dealing with less-liquid securities. For investors, mastering this approach is invaluable.
Maintaining price discipline is of utmost importance. Even when a company’s shares appear to be a bargain, they can experience significant price drops. If an investor identifies a promising opportunity yet has reservations—be it due to a lack of full conviction or limited tradable volume—it might make sense to spread out the investment. Instead of making a singular 20% purchase, the investor could opt for a series of four increments, each constituting 5% of the intended investment, spread out over time.
This phased approach allows for setting specific parameters. For instance, if the company achieves certain milestones, or if shares hit a predetermined price, it could trigger another 5% addition to the portfolio. The benefits of this strategy are twofold: an investor can average into a position that consistently meets expectations or acquire shares at progressively better prices if they continue to dip, maximizing the potential return on the same opportunity.
Company-Specific Risk
Having a portfolio with five unrelated positions can effectively mitigate company-specific risk. When your portfolio consists of multiple unrelated ideas or companies, it ensures that the negative developments in a single company, such as poor management decisions, regulatory issues, or financial instability, will have a limited impact on your overall portfolio.
With just five positions, the impact of each company on your portfolio’s performance is more significant than if you held many more positions with minimal allocations, such as 5% positions. This means that when you make correct assumptions about a specific situation within one of these five companies, it can have a substantial impact on your portfolio’s performance, potentially leading to significant gains.
A focused portfolio of five unrelated positions strikes a balance between diversification and impact. It allows you to spread your investments across different ideas, mitigating company-specific risks, while also ensuring that your correct assessments and actions have a more meaningful influence on your overall portfolio returns.
Investors occasionally grapple with a lack of conviction in their top investment choices. Additionally, the volatility of a concentrated portfolio might prove too taxing for some to endure year-to-year. One way to alleviate this is by adjusting the size of each investment within the portfolio.
For example, if we determine that 20% at-cost positions effectively influence portfolio performance while also containing the risk of severe losses, but the aim is to further dampen volatility, then cutting each at-cost investment to half of the initial percentage becomes a logical move. Holding ten positions, each at 10%, still results in a reasonably concentrated portfolio. If these positions are judiciously selected, this can help in reducing volatility.
However, one consequence of decreasing the concentration of each holding is the need to include more investments to complete the portfolio. As the number of required positions rises, the potency of each idea might diminish. Moreover, to make a significant impact on the overall portfolio’s performance, each position must appreciate considerably in value. This might tempt an investor to opt for riskier securities to counterbalance the diluted concentration.
It’s essential to understand that portfolio strategies aren’t always binary. A hybrid approach could be employed. For instance, allocating two or three 20% positions to your highest conviction ideas, while populating the remainder of the portfolio with 10% positions that hold promising potential, might offer a balanced blend of concentration and risk mitigation.
The Importance of Simplicity and Logic
An investment strategy must be simple, logical, and easy to execute. If a strategy is overly complex or lacks a clear rationale, it can be described as speculation rather than a sound investment approach. Position sizing is an integral part of a logical investment strategy, as it provides a structured framework for allocating capital.
Investment strategies that could expose an investor to a total loss on their portfolio are considered speculative. In reality, any financial instrument could become worthless suddenly due to the inherent structure of all financial markets. Rare but genuine scenarios, such as unforeseen fraud, regulatory clampdowns, or catastrophic events, could render even the most stable securities worthless. Thus, while the term “speculation” is not easily defined, it is recognizable: if a security or strategy could result in a total loss during its typical operation, it should be avoided.
Certain forms of speculation, which essentially involve making assumptions and predictions, are integral to investment analysis. They are also vital for business underwriting. Predicting various operational factors of a business based on past performance and confidence in future operations are logical exercises. Relying solely on zero-prediction analysis often leads investors to seek companies with the highest current yield or the most significant current discount to tangible value. While this might be an attractive strategy, especially for smaller investors seeking significant discounts, some of the best investments occur when assumptions are made about a currently profitable business. Confidence in these assumptions allows investors to commit for the long term. This approach mirrors business-like investment, where one remains a committed owner of shares because they recognize the shares’ current value and have confidence in their predictions based on the company’s track record.
Learning to make thoughtful predictions based on confidence in available data is a valuable skill for investors. What distinguishes investment analysis predictions from pure speculation is the potential damage speculation can inflict on a portfolio’s permanent integrity. For instance, if you’ve bought shares in a consistently performing company and made predictions about its future strategies, you might achieve above-market returns by holding onto that company for 3-5 years. If your assumptions don’t pan out, the worst-case scenario might be underperformance relative to peers and the general market index. However, you still have the opportunity to salvage value from your shares and reinvest elsewhere. By being consistent in your conservative predictions, any losses from incorrect assumptions remain recoverable.
In contrast, speculation is akin to walking a tightrope without a safety net. High-risk predictions seeking high rewards, using callable or floating leverage, buying overvalued shares dependent solely on growth, or making macroeconomic bets with disastrous potential outcomes should be avoided. Almost all financial transactions can be intelligently structured to include some form of price protection as a safety barrier. Committing to a logical and straightforward investment strategy, rather than a complex one, is the best way to minimize risk and maximize returns.
Executing an Investment Strategy
Executing an investment strategy effectively is crucial, and having a well-thought-out approach can offer protection against both company-specific risk and systemic market risk. One such strategy involves focusing on a portfolio with just five positions, which can provide a robust balance between diversification and impact.
With a portfolio of five positions, you can effectively manage company-specific risk. It’s an approach that allows you to stay agile and responsive while still minimizing exposure to any single company’s setbacks. This way, if one investment underperforms due to poor management decisions, regulatory issues, or financial instability, it won’t unduly affect your entire portfolio.
Moreover, the five-position strategy offers flexibility. You can employ a “basket” approach to create a 20% position within your portfolio. For example, if you have a collection of investment ideas that share a common theme or would all benefit from similar market conditions, you can allocate four 5% positions to collectively make up a 20% position in your portfolio. This approach allows you to retain the benefits of a concentrated portfolio while diversifying within the 20% allocation to capture potential market opportunities more effectively. This is similar to the portfolio of ten 10% positions described earlier. However, this approach groups a select number of positions under a similarly themed basket, which can be thought of as a collective position.
In essence, the five-position strategy combines the advantages of concentrated and diversified portfolios, offering a balanced and flexible way to execute your investment strategy while addressing both company-specific and systemic risks.
Conclusion
Position sizing is indeed a critical element of successful investing, and different strategies work for different investors. Let’s explore the concept of a five-position portfolio and its effectiveness in mitigating risk and potentially generating superior returns.
A five-position portfolio involves allocating a specific percentage of your investments to just five carefully chosen securities. This approach has several advantages:
- Risk Mitigation: Embracing a focused portfolio of five positions empowers you to closely monitor and deeply comprehend each investment, enhancing your ability to make well-informed decisions. While diversification across various asset classes is a widely used risk management strategy, a concentrated portfolio ensures that you can fully capitalize on high-conviction ideas. In such a scenario, if one position encounters a downturn, its impact remains proportionate, thereby allowing you to address and mitigate risks more directly, and potentially leading to a quicker and more strategic response to safeguard your overall portfolio.
- Superior Returns: By concentrating your investments in a few select positions, you have the opportunity to focus on high-conviction ideas that you believe will outperform the market. This can lead to potentially superior returns compared to a highly diversified portfolio that includes a multitude of average-performing assets.
- Simplicity and Ease of Execution: Managing a five-position portfolio is simpler and more manageable for most individual investors. It allows you to thoroughly research and stay up to date on each investment, making it easier to react to changing market conditions and news.
However, it’s important to note that a five-position portfolio can be more volatile than a portfolio with a larger number of positions, such as a fifty-position portfolio. This higher volatility is because a poor-performing asset has a more significant impact on the overall portfolio when there are fewer positions to offset losses. Therefore, this strategy may not be suitable for risk-averse investors who are excessively concerned about year-over-year volatility.
In such cases, a twenty-five-position portfolio might strike a balance between risk and diversification. However, it is typically more suitable for institutions with significant assets under management, like pension funds that have specific obligations coming due. For most individuals and institutions, a five-position portfolio is a practical choice.
It’s worth mentioning that famous value investors like Warren Buffett and Charlie Munger, who have enjoyed outstanding long-term performance, used a conviction driven approach in their early partnerships. Their success demonstrates the potential of a concentrated portfolio strategy.
Nevertheless, there isn’t a one-size-fits-all approach to portfolio sizing. Other renowned investors like Peter Lynch and Walter Schloss achieved exceptional records with more diversified portfolios. The key is to understand your risk tolerance, investment philosophy, and financial goals, and then align your portfolio size accordingly.
In conclusion, portfolio sizing is a highly individualized decision. Whether you choose a five-position portfolio for simplicity and potential superior returns or opt for more diversification, it should align with your investment strategy and comfort level. The experiences of famous investors show that success can be achieved through various approaches, but what matters most is understanding the psychological implications of your portfolio size and how it affects your ability to stay disciplined and benefit from long-term returns.
The information presented in this article is the opinion of Jacobs Investment Management and does not reflect the view of any other person or entity. The information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies. This is for information purposes and should not be construed as an investment recommendation. Past performance is no guarantee of future performance.