Position Sizing : How to Structure Your Portfolio

It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong — George Soros

Michael Maubossin in his article “Size Matters: The Kelly Criterion and the Importance of Money Management” , begins by laying out what is required by the investor in order to maximize wealth. The investor is first required to find situations in which they possess an analytical edge and secondly the investor needs to allocate the appropriate amount of capital to that situation.

However most investors treat position sizing more like an after thought and not a crucial component in successful portfolio building. Two investors holding the same stocks can achieve different returns if one investor adequately sizes their positions.

However the goal of position sizing shouldn’t be to maximize returns but the focus should be on downside protection. James Dinan viewed position sizing as a “function of not how much you can make, but how much you can lose.” We all have heard of Murphy’s law: Anything that can go wrong will go wrong. In investing anything can happen, and your goal should be that you are able to see another day when shit hits the fan.

The investor is thus aiming on not over owning a loser and under owning a winner.

There are many ways have been proposed on how an investor can go about position sizing. An investor can equally weigh their portfolio, either by percentage or fixed dollar amount. An investor , for example, can say that they will have 10 positions and each position will weigh 10% or that they will invest a fixed dollar amount of $5000 in every position.

Another method is using the Kelly Criterion. The Kelly Criterion, introduced by John L. Kelly Jr. in a 1956 paper on optimal betting strategies, has been influential in both gambling and investing. While Kelly originally developed the criterion to maximize the growth of capital in gambling scenarios, it gained wider recognition through the work of renowned investor Ed Thorp, who adapted the method for use in financial markets. Today, the Kelly Criterion is predominantly used by professional traders and institutional investors to determine the optimal bet size for investments based on their edge and risk, aiming to achieve the highest possible growth while managing the risk of significant losses.

Using the Kelly Criterion in investing is tough because it needs exact knowledge of the odds of winning and losing, as well as the expected returns. In investing, these numbers are hard to estimate due to market complexities and unpredictability. Unlike gambling, where odds are clear, investing involves many changing factors like economic conditions and company performance. This makes it almost impossible to know the exact probabilities and outcomes, leading to uncertainty and often risky bets.

Position sizing is both an art and science and there is no one size fits all strategy. I personally have no set formula on how I allocate my stocks but there are few things I consider:

1. I have a set percentage that I won't let any single position exceed to ensure my downside protection.

2. Similarly, I avoid holding minuscule positions, such as a position being 0.03% of my portfolio.

3. I factor in my confidence level in the stock; higher confidence might lead to a slightly larger position.

4. I consider the risk associated with the specific stock. I am willing to go as high as 15% in a single position for a largely followed large cap, but I would not do that for a small cap stock

5. I hold my positions for long periods of time

6. I only invest when I have an edge

7. I always have a cash position in case an opportunity arises

Effective position sizing is crucial for successful investing. By carefully considering how much to allocate to each stock, you can manage risk, protect your downside, and capitalize on opportunities. Remember, only invest where you have an edge, whether it's through superior knowledge, insights, or a unique perspective. A well-thought-out position sizing strategy not only helps in safeguarding your portfolio but also positions you to achieve higher returns over time. Balancing the art and science of investing, staying adaptable, and continuously refining your approach are key to mastering position sizing and enhancing your investment performance.