Regardless of whether your investment horizon is measured in minutes, days or years, proper position sizing is a vital component of any money management strategy.
This article will dive into the all-too-often overlooked subject of proper position sizing.
What is Position Sizing?
Position sizing is the component in your strategy that guides you in determining how much capital to allocate to a particular investment. Put another way, position sizing helps you figure out how many shares to buy if you’re bullish, or to short-sell if you’re bearish.
While it may be easier to follow simple logic like “buy more if you’re confident, and less if you’re not as sure,” this is a sure-fire way to deplete your capital over time. Position sizing is at the heart of risk management because it revolves around answering: How much are you willing to lose on this position?
This is a difficult, but equally important, question that every trader and investor should consider.
Importance of Proper Position Sizing
Why is proper position sizing so important?
As the legendary George Soros once said, “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong." And answering how much money you could make (or lose) starts with determining how much capital to allocate to begin with.
Perhaps the best reason as to why position sizing is such an integral part of being successful over time is the fact that it can help to protect against catastrophic losses. If you have controls to determine how much you allocate per trade, you are more likely to find yourself in a better position in the event of a swift market sell-off than if you rely on going with your gut, in which case you could see a big chunk of your account evaporate.
While the financial loss is obvious, there is a big mental hurdle to clear as well after enduring a serious setback. Proper position sizing can not only help to protect your capital, but your confidence as well.
How to Determine Position Size
As is the case with other investing principles – be it picking a strategy or defining your entry and exit methods – proper position sizing is subjective. With that being said, there are some general guidelines worth considering. This range could span from 0.25% to 10% or more per position depending on a number of factors, such as your experience level, general market conditions, security selection and time horizon.
For example, a 5% allocation for a total portfolio of $100,000 means allocating $5,000 to any one position. Now let’s assume the desired security is trading at $25 per share. Next, to figure out how many shares to buy you must divide your desired position size, in this case $5,000, by the share price. That is 5,000 / 25 = 200, or 200 shares.
See more examples here along with an explanation of equal dollar vs. equal risk strategies.
ETFs Are Changing the Position Sizing “Rule of Thumb”
While it may have been foolish to go beyond a 5% allocation just a few years ago, the advent of ETFs has certainly changed this. Because of their broad-based nature, equity ETFs are inherently more diversified than single stock positions, and as such, it is not unreasonable to allocate 10%, 20% or even 50% to a single fund. For instance, the Vanguard Total World Stock ETF (VT ), which holds over 7,000 securities spread out over more than a dozen countries, could reasonably account for a large share of an individual’s portfolio.
The same goes for fixed income ETFs. For example, the iShares Core U.S. Aggregate Bond ETF (AGG ) holds over 5,000 securities spanning across everything from Treasuries to corporate bonds to mortgage-backed securities.
On top of providing greater diversification under a single ticker, ETFs are also embraced for their low management fees and tax efficiency. These features have pushed many to contrive ways of achieving well-balanced exposure with as few tickers as possible and really push the limits of their portfolio’s cost efficiency.
Want a simple portfolio? Consider the following 25 All-ETF model portfolios each comprising of just three funds in total.
Bottom Line
Proper position sizing is at the cornerstone of every successful strategy, be it day trading or investing for retirement. While proper position sizing won’t protect you from losing money, it can protect you from catastrophic losses that take a while to recover from, both financially and mentally. Be sure to ask yourself how much you’re willing to lose on a trade before pulling the trigger, as this will naturally guide you to determine the right amount to purchase and where to set your stop loss.
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