Position Sizing is Personal
Thoughts on "How big is too big?" and "How small is too small?"
It is time to introduce you to a common theme of mine: “Everything Everywhere is Situational”. I believe this to be true in general, but it is particularly true for me in investing. When I started investing and stock picking, one of the things that attracted me to it was the rational, numbers-based analytical process that I could use to review investments. To take just one small example, look at "low P/E” value-based investing strategies. In this strategy, you select a basket of stocks that have very low prices compared to their historical earnings. And as a broad strategy, it has worked very well historically. But when you start to implement it with a given company, then you quickly start to see where each unique situation is different. I once invested in a company that made controllers for the fluorescent tubes used to backlight TV screens. The company was cheap on price to earnings basis. Of course, this metric is backward looking. It is based on history. Investing successfully is all about the future. In this case, the company was cheap for a reason. Flat screen TVs didn’t use fluorescent backlighting. I knew this. The siren song of a cheap stock was too much to resist. The outcome is predictable in hindsight, their core business gradually eroded. They couldn’t pivot quickly enough to new products and their stock price plummeted over time.
Another area where I learned about situational awareness concerns position sizing. Early in my investing career, I developed some rules regarding position sizing. I’ll summarize with a few bullet points:
My basic portfolio is 20X5. Twenty positions at 5% weightings each.
Since I invest based on my own research, the initial position size must be relatively large compared to the desired target. I.e., don’t take small positions. So the first purchase was often 3-4%. I did this to ensure I had appropriate conviction in each company in my portfolio.
The target holding period was 3 years, and I wouldn’t sell before one year. This ensured that I gave my investment thesis time to work out and didn’t panic and sell early if the price dropped. If you liked it at $10, you should love it at $5.
I had more rules, but that gives you a flavor. I started to have problems with my “rules” because of, well, … me. Let’s take the first one to illustrate. I would often buy a company at, say, a 3% position. Then it would run up in price, making it a 5% position. Do I add more and take it over 5%? Why did it run up - was it market-related (the whole market was up), or was it because the company did something great? What happens when a company executes well and becomes 10-15% of your portfolio? Do you sell just because it’s now larger than your target?
Over time, I’ve become more nuanced with my rules. Mainly because of things that I have learned about myself. Taking just position size, for example, I once owned a company that did well and became 40% of my portfolio. Shortly after, it dropped 30%. That was a big single hit to my portfolio. I learned that I don’t like that. Now, I usually start to trim positions if they get to 20% or so and have rarely let positions get larger than 25%. I know of investors that wouldn’t hesitate to hold 40-50% of their portfolio in one position if it was a high conviction idea. But that is not for me.
Here are a few things I’ve learned about myself that have forced me to adapt my rules-based approach:
When I make a mistake, I usually realize in the first couple of quarters that I own something. I have no problem selling in less than a year now if that is the case.
I don’t like researching a company, and the share price starts to levitate away from me. As a result, I am OK taking small positions, 1-2% of the portfolio, in companies that seem very promising based on initial research. Sometimes, they fade from my limited attention span, and I never get full conviction in them as an investment. So once every year or two, I have to clear out some small low conviction positions. And that is OK.
Sizing up my positions is much more a function of watching how a company executes than valuation or an arbitrary size target.
I expect many things I wrote above will change 5 or 10 years from now. I hope that happens. That means that I am learning and growing as an investor.
Looking back, it has been fun learning about myself and what I can take and not take in the world of investing. Learning about yourself can be a valuable endeavor in investing. But it is rarely painless. As you continue your investment journey, I encourage you to give yourself the latitude to learn, change and grow. I find that once my investment strategy is more closely aligned with who I am, I am more comfortable, and hopefully, that will make me a better investor over time.
