Common sense position sizing for investors

Peter Lynch is well known for being the best-performing mutual fund manager in the history of money management. From 1977 to 1990, as manager of the Magellan Fund at Fidelity, he clocked an incredible 29 percent in annual returns. He might be just as well-known for coining the term “multi-bagger”, which appeared for the first time in print, in his book “One up on Wall Street’, published in 1988.

The word has its roots in that most American pastimes, baseball, where bags represent “bases” crossed by the runner during a play. But investors world-over have embraced it, as the ultimate investing prize.

Seeing a three-digit return next to a holding feels wonderful. Like sipping a fantastic, leisurely, luxurious cup of coffee.

Does your portfolio currently show one or more multi-baggers?

What is the percentage impact they have had on your net worth?

If multi-baggers are the ultimate achievement badge for an investor, then having a few of them in your portfolio should mean you’re close to checking off your financial goals. But it rarely seems to work like that.

Good traders worry all the time about blowing up. There is a ton of literature on position-sizing for traders, the intended outcome being to cap exposure to any position.

The distinction between “traders” and “active investors” is hazy at best, but in this context, let’s think of an active investor as someone who, at the time of buying, expects to hold a stock for a year or more.

Most active investors have the opposite problem to traders. Since most of them do not have clear rules when buying a stock, a common problem is in not having a meaningful allocation to their “multi-baggers”, read as “best-performing holdings”.

Two ways investors end up under-allocated to their winners:

To begin with, not having target allocation, and hence buying arbitrary amounts of a stock e.g. “100 shares” of a company, token amounts “Rs 50,000 or 1 lakh worth”. What’s more, is that arbitrary number tends to stay constant even as the overall portfolio grows.

Not buying more of a stock because it has gone up after a small initial buy.

Consider this, the next time a stock that is up or down 9 percent is top of mind while it makes up a grand total of 0.2 percent of your portfolio.

If the market moves by a pedestrian 10 percent at the same time, absolute gain on the “market” part of the portfolio is still 6.6 times the gain on your 3-bagger.

Seems to be very little to show for identifying a brilliant stock.

How much to allocate to active positions, deserves some attention.

Let us say you have done the research to find a stock that you think could double in the next three years. You can not be sure but you are optimistic.

Chart 1 is a simple representation of the impact of starting allocation to this stock while the rest of the portfolio tracks the market near its long-term 12 percent average.

Reading this chart: Assume you start with Rs 100. You identified a stock that could double in 3 years and you were right. x-axis shows how much of Rs 100 you allocated to this active pick, assuming the remainder goes into a low-cost index fund. y-axis is portfolio value after 3 years. The colours show how much of your final portfolio value is made of the active pick versus the rest of your portfolio, in this case, the index.

So, a zero percent active pick, 100 percent index allocation gets you to Rs  140.5 (12 percent CAGR over 3 years), while a 100 percent active pick allocation gets you to Rs 200 (double, since we are assuming a 2-bagger).

Chart 2 is just an easier way to see the incremental impact of allocating to the 2-bagger, compared to the index. Remember you started with Rs 100.

At zero percent allocation to the active pick, you obviously see no incremental return, while if you went all-in on that stock (which would be madness), you get Rs 60 additionally for every Rs 100 invested. Notice, how at 100 percent allocation, your total return is 100 percent but you take out the 40 percent you would have got from the index anyway and end with 60 percent incremental return.

Come back to why you go through the effort of making active investment decisions over investing in an index fund.

The index is not standing still. So any “active” stock selection effort needs to outperform with respect to the index. And to outperform, overall i.e. the cumulative impact of active stock picks needs to beat the index. If you consider the opportunity cost of time and effort involved, active investment decisions need to beat the index by a decent margin to be worth it.

Literature says holding between 12 and 20 stocks offers reasonable protection against unsystematic risk i.e. risk inherent in a specific stock. We arrived at a similar range in our analysis of the optimal number of stocks for the momentum portfolio. One reason adding more stocks beyond a point does not help, is because historically stocks are more correlated when going down than when going up.

So, your upper allocation limit or “lose sleep” limit, to any position could be somewhere between 1/20 = 5 percent all the way up to 1/12 = 8 percent.

Take a moment to think, How much do you end up allocating to fresh positions, whether in a lump sum or overtime?

There are a few simple things to do to incorporate position sizes in your investment thinking:

First, clean up: Download current list of holdings, add a column “Percentage of Portfolio”, filter for holdings under 1 percent. Exit them. It doesn’t matter whether the next Amazon or the next Suzlon is in there because they won’t move the needle, but they clutter up the screen and mind with their greens and reds.

Assign Conviction levels: Look through the remainder, assign Low-Medium-High conviction levels to each holding. This is not about a DCF valuation exercise but putting down your level of confidence that made you buy the stock in the first place. Note, “holding” here can mean individual stock, mutual fund, or even a set of stocks you transact as a portfolio e.g. if you allocate to a momentum portfolio, you wouldn’t assess each individual stock but the portfolio itself.

Take Action: The grid below is not at risk of being a candidate for a Nobel Prize in Economic Sciences.

It’s a simple grid of  Current Allocation versus Conviction, the idea being to ensure a certain minimum allocation to High conviction stocks and to exit or at least reduce exposure to the low conviction ones.

Low Conviction Stocks: Why not exit all of them? That’d be rational. But to account for the resistance that comes from making big changes at once

Medium Conviction Stocks: Probably where we’d end up spending the most time. At the first pass of assigning conviction, we’ll have a bunch of these, like when guests are coming over and we stuff the living room mess out of sight into the closest drawers. Either bump medium-conviction stocks to “High” or downgrade them to “Low”. Tough as it will be to move things out of this noncommital bucket, that’s the work we’d need to do as active investors. And if you hate doing this, then ask yourself whether you really enjoy active decisions. And if not, buy the index.

High Conviction Stocks: Making sure to not be below a minimum allocation in these, and where a stock or two might have become an outsized part of the whole, revisit and either continue holding or reduce.

There’s an added benefit to paying attention to your position sizing. It makes you more selective about what you hold without making you feel you need to come up with all the answers.

You don’t need to have a ready set of 15-20 stocks at any given time irrespective of market conditions.

For instance, given prevailing market conditions, if you only find seven stocks you like, you allocate a clear percentage of your portfolio to those seven. The rest can go to work in a passive portfolio, to be drawn down as and when you find other stocks to add.

Like new habits, this exercise can feel unnatural at first. After all, aren’t we meant to be poring through balance sheets to unearth the next Bajaj Finance and not dealing with mundane things like position size? But give it a few repetitions, and this framework automatically kicks in for every new purchase and sale.

Being able to look at all daily price movements in the context of your overall portfolio can be wonderfully liberating.