equity position size (l): professionals

how much of a stock is too much?  how much is too little?

The answer is, of course, that it depends. The biggest factor, to my mind, is whether you have developed the skills to analyse the companies whose stocks you own and are willing to put in the (significant amount of) time necessary to do so.  In other words, there are different rules for active professionals and for you and me.  But there are both subjective and objective guidelines.

In the most general sense, positions shouldn’t be so small that if you put in the time and they work out the resulting gain is so small that you don’t notice the difference.  On the other hand, they shouldn’t be so large that if they crash and burn they make a horrible dent in your lifestyle that you will be years in recovering from.

From a psychological point of view, you don’t want to take on so much risk that you can’t get to sleep at night.

In my experience, professionals starting out tend to build positions that are too small.  If, for example, what you think is your best idea ends up being .5% of your portfolio and goes up 20% more than the market during a year (i.e., if your idea is a success) you’ve added .1% to your portfolio performance.  No one will notice.

I have less direct experience with private individuals.  My impression, though, is that virtually no one reads the basic information about itself that a company sends to shareholders and files with the SEC–annual and quarterly reports, and the SEC equivalents, the 10-K and 10-Qs.

some specific rules

for professionals

growth vs. value

On average, US-based value investors hold about 100 positions.  Their growth counterparts typically have more concentrated portfolios, with around 50 positions.

Part of this is custom or habit.  To me, and I’ve worked in both value and growth shops, the sense behind the difference is this:

Value investors use more mechanical screens and deal in a universe of more mature companies, where information is more readily available.  So they can rely on third-party research to a great degree.  In addition, value investors typically have a better handle on what they think will happen rather than when the hoped-for favorable developments will occur.  Nevertheless, like all professional investors, their performance is judged by consultants on a yearly basis (or even shorter time periods).  The larger number of positions increases the likelihood that something good will happen in a given year.

There are fewer true growth stocks than there are good value stock candidates.  Growth companies are often in new or highly technical industries, and so typically require more intense research than value stocks.  Less high-quality information is available from third parties so the manager and the in-house research department have to do a larger part of the work themselves.  The smaller universe to choose from and the greater amount of effort needed to keep up with company developments both argue for more concentrated portfolios.

mutual funds

Stock mutual funds are subject to diversification requirements mandated by Federal regulation.  These include both sector/industry concentration limits as well as caps on the size of individual positions.  These rules have two outstanding peculiarities:

–25% of the portfolio assets are exempt from the diversification rules.  As far as the SEC is concerned, you can use that 25% to build one gigantic position (and I’ve seen some competitors do so) and it’s still ok.

–The position size limitation rule that applies to the other 75% is usually stated as prohibiting that you’re not allowed to have individual stock positions bigger than 5% of the fund’s assets.  That’s not quite right.  The rule is that the manager is not allowed to make a purchase that will cause a position to breach the 5% ceiling.

The difference is that you’re not required to sell any part of a position that exceeds 5% of the assets, either because it has performed much better than the rest of the portfolio (think: AAPL) or because the fund is having redemptions.  In the latter case, the manger can opt not to sell any part of a 5%+ position, making it bigger by default.

Actually, for holders of actively manager funds, it’s probably worth your while to take a look at the list of holdings contained in shareholder reports.  The vast majority of funds abide by internal rules that are much more conservative than the ones from the regulators. Occasionally, though, I’ve seen high-profile funds that are run in a very highly concentrated fashion.  Typically, the fund company won’t go out of its way to call shareholder attention to this potential risk.  And because third parties rely on academic definitions of risk as being short-term fluctuations in net asset value, they won’t pick up on this either.

Tomorrow:  rules for you and me.



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