Position Sizing: Why Not Using This Strategy Is The Best Way to Lose Everything
by Alexander Green, Chairman, Investment U
Friday, August 8, 2008: Issue #835
Back when I was still managing money 10 years ago, I had a client who transferred in a rather sizable account.
There was only one problem. Over 90% of his net worth was tied up in a single stock, Ericsson. He refused to use a trailing stop or sell a share of it or even to use a position sizing strategy.
I warned him it was crazy to have his entire financial future riding on one stock, especially since he was retired.
"That's what everybody keeps telling me," he said. "But the stock keeps going up. I'm glad I ignored them all."
I congratulated him that the stock had appreciated so nicely. But I reminded him there might come a time when it didn't do so well. But he was stubborn. He wouldn't part with a share. Furthermore, he grew weary of having the same conversation. He transferred his account out again.
You may already know how this story ends. From a high of over $105 in March 2000, Ericsson took a breathtaking dive. It traded at less than $5 two years later. This is the kind of mistake - especially when you're already retired - from which recovery is simply not possible. However, I sometimes see other investors making similar mistakes.
Every so often a reader will come up to me at an investment conference and proudly announce, for example, that he has his entire IRA invested in one of my stock recommendations. This is meant as a compliment, I realize. He wants to show me he has confidence in my stock selections.
But it makes me cringe inside...
Properly Diversify With Basic Position Sizing
Just as the Ericsson shareholder failed to diversify properly, so do many investors who fail to follow our basic position sizing strategy.
You shouldn't put more than 4% of your equity portfolio in any single stock. (At least initially, anyway. It may grow to be a much larger percentage. But that's fine as long as you protect your profits with a trailing stop.)
Here's why you should follow this advice, especially if you consider yourself risk averse:
- Our policy is never to let a stock fall more than 25% below our purchase price without selling it.
- If you take the maximum loss (25%) on your maximum position size (4%), it means the value of your stock portfolio has fallen just 1%.
- And if you have no more than 60% of your portfolio in equities, as we currently recommend, the maximum potential harm done by a single stock cratering is this: Your total portfolio is worth six-tenths of a percent less.
Most grandmas could live with that.
How to Maximize Returns & Limit Risk
Everything we do - asset allocation, trailing stops, position-sizing and stock selection - is done with an eye to not only maximizing returns but also limiting risk.
It's fine if an individual stock grows to become a significant percentage of your total portfolio, provided you are running a trailing stop behind it to protect your profits.
But don't let your confidence in any stock - or any stock picker - allow you to abandon basic money management principles.
As Thomas Jefferson once remarked, "In matters of style, swim with the current. In matters of principle, stand like a rock."