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Position Sizing
The Smart Profits Report: Issue #193
Monday, March 21, 2005
Position Sizing: The Most Powerful Investment Concept
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
I know it’s irresistible to back up the truck when you hear about a good play. We all feel that way when we find one of those special ones. After all, if I am confident enough to buy $10,000 worth of a stock or an option because I think it will double in price, why not take out a second mortgage and then buy it on margin to boot? After all, it’s a sure thing!
Before you take this kind of step, however, try to remember these two rules:
- There is no sure thing in investing unless you are on the inside… and even then you may really be on the inside, wearing stripes and trading recipes with Martha’s former cellmate.
- Don’t forget rule #1.
Over the years, I have heard many subscribers lament about how much they loved the story of Company X just to invest the bulk of their 401k or IRA into the situation. Or, how they knew so much about their own company that they decided to put most of their money in company stock. Then, when the situation did not pan out, they either lost it all (Enron, K-Mart) or got a 50% haircut. All the way down they kept repeating, “This can’t be happening.”
Well, it does happen, often. There is a solution, one that really works, but hardly any trader takes notice of. Every so often I ignore it, just to learn a hard lesson over again. The lesson is position sizing.
Sounds pretty exotic, almost what you would expect to see as a chapter heading for “Everything You Always Wanted to Know about Sex But Were Afraid to Ask.”
If You Don’t Get In Trouble, You Won’t Have to Get Out of It
Position sizing is the most critical and important lesson that I can share with you about investing. It is a simple concept, yet powerful. It’s the one practice that separates investors who succeed (especially in options) from those who periodically wipe out and either have to save up to start over, or just give up entirely. And, easy as it is, powerful as it is, most investors ignore it.
Position sizing means investing the same amount in every investment. Period. End of story.
Position sizing is easy. For example, let’s say you have a $100,000 portfolio. Instead of investing $80,000 in a fuel cell company and the balance across 20 blue chips stocks and options, you would be equally weighted across the board. So if you had 25 positions and $100,000 to invest, then you would put no more than $4,000 in each investment - including that incredible fuel cell company.
How to Turn a Mortal Wound Into a Mere Scratch
Sooner or later, you’re gonna get a bummer. It happens to every investor. But it doesn’t have to hurt anything significant - except your pride for a day or two.
Nervous amateurs tend to remember every loss and fret over each one. They are always trying to make up for it. They want to get even again. Then they get crazy. Successful pros don’t do that. They don’t get even; they stay even. The secret isn’t in better stock picks; it’s in better control.
Let’s say that your surefire investment in fuel cell stocks flamed out and fell by 30% overnight. If you had ignored position sizing and put $80,000 of your $100,000 portfolio in fuel cells, you would’ve lost over $24,000 in a heartbeat. In the position-sized portfolio, equally spread across 25 investments, your loss would only be $1,200.
But there’s a bit more to it than that…
How to Cheat a Little Without Breaking Rule No. 1
No matter how much people want to believe in theory, real life investing is different. Investors all too often invest emotionally. If you are one of these emotional investors, then use a more liberal version of position sizing.
Instead of position sizing with each individual stock or option, position size with sectors. So, if you are big on utilities or telecoms, then position size your portfolio in such a way that you limit your investment in each sector to something like 10%, and add a strict stop-loss system. That way you can be overweight in one company or sector, but not so overweight that you will need radical portfolio surgery to come back from the edge.
With this System, Safe Options Are Possible
Position sizing applies to options, as well. If you have a $10,000 portfolio devoted to options, then you should allocate it in a way so that you are not at risk more than 5% or 10% in any one position, for the safer longer-term options strategies such as LEAPS (long-term options) or covered calls. For short-term trades, which are riskier, 5% is as high as you should go. That way, with a good system, you will still come out profitable in the end as your winning trades carry you forward.
Position sizing in addition to a stop-loss will give you the kind of control over your fate that you can’t get any other way in investing.
Good Investing,
Karim Rahemtulla
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Today’s Smart Profits Crib Sheet
- For more on position sizing, check out Smart Profits #229, Option Position Sizing: How Much to Invest In Each Option Trade.
- Check out the Smart Profits Glossary if you find any options terms that you were unsure of, like “position sizing” or ” covered calls” in today’s article.
Related Articles:
- Position Sizing Safeguards: Prevent Corporate Lies From “Cooking” Your Portfolio
- Options On ETFs: Increased Safety and Profit Potential
- Portfolio Position Sizing: The “10% Rule” for Safe Option Profits
