Position Sizing Strategy for Long-Term Success

Written by

Jae Jun

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What You’ll Learn

• A different way for value investors to look at position sizing.
• Misconceptions value investors have about traders and why it’s wrong
• Guidelines for position sizing to improve your investing strategy

Thought I’ll share this short interview with Brian Hunt on a position sizing strategy. Hunt is a successful private investor and trader, and the Editor in Chief of Stansberry & Associates Investment Research.

Happens to be one of the largest independent financial publishing firms.

Before I get into it, keep an open mind about this.

I’m a value investor. It’s easy to recite whatever Buffett and Graham said on the topic of diversification, but remember that everyone has their own method. Towards the end of Graham’s career, he held a large number of stocks to prevent what happened to his portfolio during the great depression.

Walter Schloss held a huge number of stocks and didn’t bother understanding the companies he bought. He just bought them at cheap fundamentals and flipped them.

Peter Lynch held hundreds of stocks in his mutual fund and is still on record as one of the best investors.

Do you see the problem?

It’s that people believe a value investor has to invest a certain way.

By this, I mean things like:

• don’t buy and sell often
• know everything about the business you buy
• hold small number of positions and bet big

Yes, it is good to follow these guidelines, but as you can see above with the super-investors, many don’t fit this mold. And there are more names I did not mention.

Another false idea is that value investors tend to believe that you must buy low and sell high. Wrong.

Some of the best super investors buy high and sell higher.

“Buying at a fair price” is a nice way of saying the same thing. And yes, Buffett buys high and sells higher (when he does sell). Coca-Cola was not cheap when Buffett started purchasing.

The point I’m making is to show the silly mantras and sound bites we hold onto as value investors. We talk about overcoming behavioral bias and all that, yet fail to realize that we also live within our own value investing biases.

Why is it that position sizing and actively managing a portfolio is seen as “trading”. It shouldn’t be.

I’m a firm believer that there is a lot to learn from traders. Not the trading part, but the framework, the ideas, the time dedicated to the craft, and the discipline of the best ones.

Munger talks about multi-disciplinary approaches, yet why do value investors immediately reject the framework of traders without second thought?

Outside of my own lucky trades, I’ve seen big improvements in my results once I improved position sizing, and got better at managing my portfolio – which includes disciplined buying and selling. And it’s not just selling when a stock reaches intrinsic value.

• I’ve held onto winners longer and let good companies grow into their valuation.
• I have gotten out of losing positions, before it experienced huge drops that would have affected my bankroll.
• I’ve sized my bets differently realizing that my best ideas weren’t always the best. My 5th best idea would sometimes turn out to be the best.

Keep an open mind, and I encourage you not to dismiss the position sizing strategy ideas from this interview, simply because it’s coming from a person with a trading background.

I also define risk as the probability of losing money. Not stock price movements like the interview suggests. But the word risk was used to keep it in context with the interview.

Why is Position Sizing so Important?

• The successful investor thinks in terms of what percentage of their total account is in a particular stock.
• It’s the best way for investors to protect themselves from catastrophic loss
• The catastrophic loss is the kind of loss that erases a large chunk of your investment account.
• Worse than losing money is the mental trauma

So clearly, you want to avoid the catastrophic loss at all costs… And your first line of defense is to size your positions correctly.

Good Position Sizing Strategy Guidelines

• For example, when buying a safe, cheap dividend stock, a position size of up to 5% may be suitable.
• Some managers who have done a ton of homework on an idea and believe the risk of a significant drop is nearly non-existent will even go as high as 10% or 20% – but that’s more risk than the “average” investor should take on.
• For volatile stocks? Position sizes should be much smaller… like a half a percent… or 1%.

As pupils of Graham and Buffett, you’re taught to believe that spreading your bets wide is a stupid idea. But unless investing is your full-time job, or you live and breathe investing, holding 10 positions at 10% is a tough ask for most people. There is nothing wrong with holding 20 or even 30 positions. The best ideas can often be wrong. Look at Ackman or even Lampert who went all in and have under-performed the market by over 100%.

Position Sizing Math – Protective Stop Losses

• A protective stop loss is a predetermined price at which you will exit a position if it moves against you. It’s your “uncle” point where you say, “Well, I’m wrong about this one, time to cut my losses and move on.”
• Most people use stop losses that are a certain percentage of their purchase price.

For example, if a trader purchases a stock at $10 per share, he could consider using a 10% stop loss. If the stock goes against him, he would exit the position at $9 per share… or 10% lower than his purchase price.

• Tight stop is a stop loss of 5%
• Wide stop is a stop loss of 50%

Combining intelligent position sizing with stop losses will ensure the trader or investor a lifetime of success. To do this, you need to understand the concept many people call “R.”

An Explanation of “R” to Calculate Position Sizing

• R is the foundation of all position sizing
• R is the value will risk in any given investment
• R is calculated using two numbers – total account size and percentage of the total account you’ll risk on any given position.

Let’s say Joe decides to risk 1% of his $100,000 account on the position. In this case his R is $1,000. If he decided to dial-up his risk to 2% of his entire account, his R would be $2,000. If he was a novice or extremely conservative, he might go with 0.5%, or an R of $500.

Joe is going to place a 25% protective stop loss on his ABC position. With these two pieces of information, he can now work backward and determine how many shares he should buy.

Remember… Joe’s R is $1,000, and he’s using a 25% stop loss. To calculate how large the position will be, the first step is to always divide 100 by his stop loss. In Joe’s case, 100 divided by 25 results in four.

Now, he performs the next step in figuring his position size. He then takes that number – four – and multiplies it by his R of $1,000. Four times $1,000 is $4,000, which means Joe can buy $4,000 worth of ABC stock… or 200 shares at $20 per share. If ABC declines 25%, he’ll lose $1,000 – 25% of his $4,000 – and exit the position.

• 100 divided by your stop loss equals “A.”
• “A” multiplied by “R” equals position size.
• Finally, position size divided by share price equals the number of shares to buy.

• A tighter stop loss means you can buy even more shares.
• If you’re trading a riskier, more volatile asset, the stop-loss percentage should typically increase and the position size should decrease
• If you’re investing in a safer, less volatile asset, the stop-loss percentage should decrease and the position size should increase.

…a good, “middle of the road” R that will work for anyone is 1% of your total account. Folks new to the trading game would be smart to start with half of one percent of their account. This way, you can be wrong 10 times in a row and lose just 5% of your account.

Resources

• PDF of the Brian Hunt interview
• Past thoughts on position sizing and probability
• Kelly criterion position sizing