equity position size (ll): you and me

It’s much easier to write about how professionals deal with the size and number of positions they hold in their portfolios.  That’s because money management firms create products that have certain risk parameters and leave it to customers to decide whether they want the product or not.  It’s impossible, however, to write very specifically for individuals without knowing anything about their financial circumstances and psychological makeup.  So you should take what follows as general thoughts rather than specific advice.

two issues to figure out

I think there are two aspects to the question of position size for non-professionals.  Both stem from the fact that stocks are risky investments. One is objective, the other subjective.  They are:

–Your own objective financial situation, given your age, income and accumulated wealth.  The question is how much risk–and the associated possibility of loss–can you afford to take.  Determining this is what financial planning, whether you do it yourself (probably using the tools on a discount broker’s website) or hire a professional to help you, is for.

For a twenty-something, having 90% of savings in stocks and having one or two positions that are each 5% of equity holdings is probably ok–assuming you’ve done appropriate research.  The two big equity positions amount to 9% of the person’s accumulated wealth.  By far his largest asset, however, is probably his human capital–his lifelong earning potential–rather than savings.  He has plenty of time for a risky investment to work out or to recover from even a large mistake.

For a sixty-something, on the other hand, having two 5% positions is probably also ok–relative to one’s overall equity holdings.  But that’s assuming the person in question has an age appropriate asset allocation. In most circumstances going into retirement with as much as 90% of your savings in equities is crazy.

–Your temperament, your tolerance for risk and–a factor I didn’t really understand until I stopped being a full-time money manager–the amount of time and effort you’re willing to devote to studying the companies whose stock you hold and following corporate developments.

I’ve often listened to casino company CEOs trying to position their gambling services as entertainment.  They joke that if you spend $500 on opera tickets you get a few hours of music but, unlike a casino jaunt, you have absolutely no chance of leaving the performance with any of the money you came in with.

As far as the stock market is concerned, this is a “Know thyself.” issue.  If you’re going to act on “hot tips” from a friend or from some guy on TV whose background and track record you know nothing about, you’re entertaining yourself, not investing.  You’ll probably lose your shirt.  So keep positions to negligible amounts.

One other editorial comment:  there’s a whole generation of Americans on the verge of retirement, whose pension savings are in IRAs or 401ks or other defined contribution pools of money.  We’ll likely live for thirty more years.  But there’s no monthly check in the mail from the company we worked for, like our parents had.  Our lifestyle will depend on the investment results from savings we’re responsible for managing.  Not taking much time or interest in doing so is probably not the greatest option.

let’s say you want to invest, not just entertain yourself

1.  Investing is a craft skill–like being a baseball player or a carpenter.  It doesn’t require you to be an Einstein.  It is experience-intensive, though.  This means you have to do your homework and serve an apprenticeship.  You start by investing small amounts, keeping records of your decisions, analyzing your results and thereby figuring out what you’re good at and what you’re not.  Even the best professional investors aren’t good at everything.  But they know they do a few things very well and stick to them.

2.  I’m not a fan of paper portfolios.  I don’t think they have enough meaning.  If you wanted to be a professional baseball manager, better to manage a high school team than to be in a bunch of fantasy leagues.  Start with tiny amounts of money.

3.  Over years of training portfolio managers, I’ve found that inexperienced managers always have great difficulty in making position sizes large enough to make a difference to performance.  As I mentioned in my post yesterday, a 50 basis point (.5%) position is probably not going to affect overall portfolio results one way or another.  It’s a waste of time.  In addition, if you have nothing but 50 basis point positions, you have to watch 200 stocks.  That’s an impossible task–and you’ll probably be killed by not catching your mistakes in time (that’s another topic, but trust me, it’s true).

For most seasoned professionals–growth investors, anyway–their top 10 positions make up around a quarter of their portfolios.  If you were to analyze it, the rest would probably look a lot like the manager’s benchmark index.  So the portfolio will likely rise or fall on the ten stocks big positions.  The task of monitoring them is manageable.  And if two outperform the benchmark by 20% each in a year, the manager will have about a 100 basis point gain vs. the index (it probably won’t be exactly 100 bp–it’ll depend on whether the market is going up or going down).  For US managers, that’s usually enough to put you in the top quartile.

4.  I think individual investors, once they’ve gotten enough experience to make intelligent judgments, should consider taking a (modified) page from the professional’s book.  This means:

–invest most of your equity allocation passively, through index funds or index ETFs

–complete your equity holdings with a small number of individual stocks (I have around a half-dozen, but I’m willing to spend a lot of time monitoring them)

–determine a maximum position size. Consider both the possible impact of a losing position on your equity holdings and on your overall savings.  If you’re, say, fifty years old and subscribe to the rule that your equity holdings should be the same percentage of your total savings as 100 – your age (which I think is a reasonable first approximation), then you have 50% of your holdings in stocks.

Suppose the individual stock you have the most confidence in were to be 5% of your equity holdings.   If that stock went to zero, you’d lose 2.5% of your wealth.  Is that acceptable?  If that is, then I think a reasonable approach to active management would be to establish three 3% positions and have the remainder of your equity holdings passive.

You should, of course, have a plan for what happens if your stocks go up, as well as for what you’ll do if they go down.  But the action you derive from determining a maximum position size is that you begin to trim the position if you’re fortunate enough to have it reach 5% of the equity total.  You don;t just let it grow.

–determine a minimum active position size, as well.  This is a much trickier topic than it appears on the surface.  I think positions below 1% of your equity holdings are a waste of precious analytical resources.  Let’s say you set that as a minimum size.

The complexity arises this way:  suppose you start out with a 1% position and the stock drops by 20%.  Do you average down and restore the position to 1%?  …or do you say you’ve made a mistake and sell?  A lot depends on your own level of self-awareness and your tolerance for risk.

As for myself, for example, bitter experience has taught me that if I have a large position that goes against me and I average down, disaster quickly follows.  So when a large position performs poorly nowadays, I either decide to hold on or to sell.  I never add.

On the other hand, averaging down is a standard tool of most value investors.

So alhtough it’s important to have worked out a plan, though, it will depend a lot on you as to what the plan actually is.

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