Position Sizing: How Much You Buy Matters More Than What You Buy
Editor's Note: In this special four-part series, “Foundations of Wealth,” we spotlight the miscues to avoid, the hype to ignore, and the powerful basics to embrace. The goal: To help you win in good markets and bad — and to deliver that “edge” Wall Street hopes you'll never find.
Position Sizing: How Much You Buy Matters More Than What You Buy
In my last essay I talked about asset allocation — how it's important to have a diversified mix of assets.
Different economic climates affect different businesses and asset classes differently, so some assets “zig” when stocks “zag.”
That's why an investor focused on building wealth and maintaining it will own a diversified mix of assets.
Today, I'm going to discuss why how much you buy matters more than what you buy. So, let's start with a common example.
You learn about a company with major growth potential.
The upside is more than 500%.
So, you buy A LOT of the stock. You want to truly capitalize on the opportunity.
And then, things don't work out.
The company doesn't execute.
Instead of its market value soaring 500%, its market value falls 50%.
You've lost way more money than you're comfortable losing.
It's an embarrassing and painful experience.
This is where smart position sizing comes in.
It's the great preventer of unacceptably large financial losses.
Position sizing is the part of your investment strategy that dictates how much of your investable assets you will place in any single investment or trade.
For example, suppose an investor has a $500,000 net worth.
If this investor buys $5,000 worth of a business, his position size would be 1% of his total capital.
If the investor buys $50,000 worth of the business, his position size is 10% of his total capital.
If the investor buys $200,000 worth of the business, his position size is 40% of his total capital.
Many folks think of position size in terms of how many shares they own of a particular stock or investment.
But a smart investor thinks in terms of what percentage of his net worth is in a particular holding.
Position sizing is one of most important ways you can protect yourself from what is known as the “catastrophic loss.”
A catastrophic loss is the kind of loss that erases a huge chunk of your net worth.
It's the kind of loss that ends careers and ruins retirements.
Most catastrophic losses occur when an investor takes a much larger position size than he should.
He finds a stock he's really excited about and he starts dreaming of the potential profits, and then he makes a huge bet.
He'll place 20%, 30%, 40%, or even 100% of his account in that one idea.
He'll “swing for the fences” and buy 2,000 shares of a stock instead of a more sensible 300 shares.
When the investment doesn't work out, he gets killed.
An investor who starts with $100,000 and suffers a catastrophic 80% loss is left with $20,000.
It takes most people years to make back that kind of money.
But there is indirect damage that often is worse than losing money.
It's the mental trauma of taking such a huge loss… and feeling like a failure.
Some people never recover from it.
They see years of hard work and savings flushed down the toilet.
Most world-class investors say never put more than 10% of your account into any one position.
Some professionals won't put more than 5% in one position.
Seasoned investors vary position sizes depending on the particular investment.
For example, when buying a safe, cheap dividend stock, a position size of up to 3% may be suitable.
Some managers who have done a lot of homework on a stock and believe the risk of a significant drop is tiny will even go as high as 10% or 20% – but that's more risk than the average person should take on.
If you're investing money into a startup business, a speculative stock, an option position, or anything else that is on the riskier end of the spectrum, the answer to “How much can I lose?” should be, “Every single dollar.”
That's why speculative situations are best played with tiny amounts of your capital.
Or if you're a conservative investor, not played at all.
But, let's say you just have to invest in a speculative situation.
Let's say you're buying a speculative biotech stock or a speculative tech company with just one potential “big hit” product.
With speculative investments, there is always the possibility that you could lose 100% of your money.
So, you want to use a tiny position size.
Generally, you don't want to place more than 0.5% or 1% of your net worth portfolio into a speculative investment.
That way, if the situation works out badly, you only lose a little bit of money.
You certainly don't want to put 5% or 10% or 25% of your net worth into a speculative investment. It's way too risky.
Unfortunately, most novices will risk three, five, or 10 times as much as they should in speculative investments.
It's a recipe for disaster.
If the investment doesn't work out as planned or if the broad stock market suffers a big correction, a big position in a speculative investment causes a big hit to a person's overall wealth and to their confidence.
When in doubt, always dial down your position size.
It will help you follow Warren Buffett's most important rule (Don't lose money.) and it will help you avoid catastrophic losses.
When you start as an investor or trader, you're as bad as you're going to get.
So take the advice of legendary trader Bruce Kovner and “under trade, under trade, under trade.”
Make much smaller investments than your emotions want you to make.
Make small investments to get the hang of things.
If you have $10,000 to get started as an active investor, set aside $7,000 and invest with $3,000 for the first six or 12 months.
But even after going through a training period like this, it's tough to learn not to lose money unless you actually feel the pain of losing a lot of money.
In summary: If you want to build your investment portfolio on a strong foundation, you must learn how to win big by betting small.
Focus on using smart position sizing to avoid the catastrophic loss.
Focus on limiting your downside, and the upside practically takes care of itself.
In my next essay, I'll describe how all these elements come together.
Enjoy your weekend,
Keith Kaplan
P.S. If you know someone who could benefit from these ideas, please share this email or encourage them to sign up for Money Talks (for FREE) right here.
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