A Position Sizing Lesson: Why Size Matters to All Investing Greats
By Brian Hunt, Contributing Editor
Tuesday, May 25, 2004: Issue #340
I made four times my money in JDS Uniphase. But I made one mistake with JDS Uniphase: I didn’t put enough money into the trade, and picked up a valuable lesson on position sizing. It was early 2000, near the top of the bubble, and I was getting used to making 100%-plus returns.
Reading a popular investment newsletter, I fell for the hype surrounding another tech stock, LSI Logic but I wouldn’t make the same “mistake” I did with JDS Uniphase.
“If I’m going to make four times my money again, I’m doing it with over half my portfolio,” I thought.
But something awful happened on the way to the bank: Instead of soaring in value and making me rich, LSI Logic tanked. I was out $23,000 – more than I would even spend on a car!
The LSI Logic loss was brutal, and it wasn’t the only stock I lost money on. So I decided to make a big change. I couldn’t lose that kind of money again.
I left the markets for over a year to study to find out what professional investors do that I didn’t do.
Here’s what I learned…
Position Sizing is What the Pros Do that Novices Don’t
I made all kinds of mistakes starting out, like trying to make a quick buck and buying the most popular stocks but the biggest mistake was ignoring position sizing as a powerful investing concept.
It’s amazing how few investors even consider how much money to place into one investment. That’s all position sizing is the part of your investing strategy that tells you “how much” to place into any one investment.
Position sizing provides the answers to these questions:
- Should you place 10% of your money into one stock?
- How about 50% of your money?
What All Great Traders Have in Common
After taking several big losses in my account, I decided to learn from the greats. I read a book called Market Wizards, and discovered the world’s most successful investors used position sizing by putting only a tiny portion of their money (generally 1-2%) at risk on one idea.
I then learned the specifics of position sizing from the book, Trade Your Way To Financial Freedom, by Dr. Van K. Tharp. After studying thousands of successful traders, Dr. Tharp learned that every trader making millions in the market is fanatical about using position sizing to control risk.
Here’s How You Can Use Position Sizing in Your Own Portfolio
Let’s say you have $100,000 to invest and you’re using the 1% risk model to guide your investments. If you’re using a 25% stop loss, you could buy $4,000 worth of stock and risk $1,000 ($1,000 is 1% of $100,000).
In the example above, you placed 4% of your portfolio into the stock and set a 25% stop – risking just $1,000 of your money (since $1,000 is 25% of $4,000).
Some investors use even tighter stops, in the 10%-15% range.
If you’re using the 1% risk model with a 10% stop loss, you could buy $10,000 worth of stock. You have the same dollar amount at risk ($1,000) as the first example – but you’re allowing the stock less room to go down before you sell.
Now I use smart position sizing – and I never worry about taking big losses like I did with LSI Logic. Take a look at your portfolio today and make sure you know “how much” you have at risk. That way you’ll be prepared regardless of what happens with any one position.
Good investing,
Brian Hunt
- Position Sizing: How to Limit Risk & Maximize Gains
- Position Sizing: Why Not Using This Strategy Is The Best Way to Lose Everything
- Trailing Stops & Position Sizing: Two Tips to Avoid Letting a Bad Stock Sucker-Punch You
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October 20th, 2009 at 4:28 pm
Van Tharp has come out with a new book titled Van Tharp’s Definitive Guide to Position Sizing.
The book relies heavily on using a trade simulator for estimating optimal position sizing, based upon the individual trader’s objective and definition of ruin.
An equivalent position size simulator can be found at http://www.afltools.com/positionsize.html Many of the examples from the book can be simulated, using your own objective and definition of ruin.
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