Would a $100,000,000 Loss Help You To Remember Proper Position Sizing?

Would a $100,000,000 Loss Help You To Remember Proper Position Sizing?

The Traders U E-Letter: Issue #124

Wednesday, March 2, 2005

Would a $100,000,000 Loss Help You To Remember Proper Position Sizing?

by D.R. Barton, Jr., President, Trader's U

My daughter, Meg, is the single most voracious reader I have ever met. At the age of 12, she has been reading five to 10 books per week - and she's been on that pace since she was six years old.

I tell you that tidbit to tell you this one: While reading, Meg's concentration is so intense that she literally tunes out the rest of the world. I've tried many ways of getting her attention while she's reading: gently calling her name (like THAT'S going to work), shouting, even threatening her favorite Beanie Baby. Nothing short of a tossing a crumpled paper towel upside her head seems to work.

But I have found the perfect way to get Meg's attention when she's reading: I quietly slip my hand between her eyes and the page she's reading, and presto - I have Meg's attention.

What does it take to get your attention in the area of trading and investing? Would $100,000,000 do the trick? I'll have to admit that this amount sure peaked my attention when I saw it in the paper this morning. Losing that kind of money should certainly have led to some interesting lessons.

First, the good news: You don't have to lose $100 million to learn a great trading and investing lesson this week. Someone else has already done that for you.

In fact, it was a well-respected hedge fund manager with a reportedly excellent track record who made the position-sizing blunder that cost his group of funds $100 million (out of a total of $800 million).

While I'm sure this manager didn't take a hit just so we could learn, let's use this opportunity to look at this huge loss as reported in the Wall Street Journal this morning. After a review of the details, we'll see how you can apply the lessons to your portfolio.

And that's where the bad news comes in. Chances are, you could be heading for a huge loss in your own portfolio if you don't follow some of the basic rules of position sizing that were ignored on the way to a $100 million loss.

The Anatomy of a $100 Million Loss

Let's look at how a fund could lose this kind of money in one day. First of all, this is a healthcare-based hedge fund that concentrates on biotech companies. Big one-day moves in biotech are not uncommon, and if you look at a charts of Biogen Idec (BIIB) and Elan (ELN), you'll see that these two stocks dropped 43% and 70%, respectively, on Monday (February 28, 2005) - after they announced the withdrawal of their top moneymaking drug from the market.

The hedge fund in question was following a strategy of "concentrated investment," by taking a huge position in one stock, or in this case, one idea. Both BIIB and ELN have profit interests in the drug that was pulled from the market.

The "concentrated investment" strategy is also known by several other names including: "betting the farm" and "putting all (or most) of your eggs in one basket."

In other words, "concentrated investment" is just a euphemism for poor position sizing.

To make matters worse, the hedge fund's rules required that no more than 15% of the funds be held in any one position. The fund's managers got around this stipulation by investing in different stocks that were tied together by the same product and upped their exposure to 25% of the fund's equity.

In short, the fund had a position size that was too big when the worst possible outcome happened. And they paid $100 million dollars for the lesson.

Give Your Portfolio and Strategies a Check-Up

What can you do to protect your portfolio from taking a similar hit? Here are three simple suggestions:

Know your risk on every investment or trade. This may sound simple, but many people enter a trade without knowing the precise point where they'll get out if the trade moves against them. This is typically called a protective stop. If your strategy doesn't include a protective stop then drop everything and add a rule for this critical item! Note that for some strategies, you risk all of your investment (for example your option expires worthless or your investment in a distressed stock goes bankrupt). In this case, your risk is 100% of the invested amount. For most folks, the "get out" point is long before zero.

Risk a small amount on any one position or idea. As a useful guideline, you should risk a maximum of 1% of your equity on any one position or idea. There are several good reasons for risking this small amount on every trade or investment. The first is that you can sustain many losses in a row without blowing out your account. The second is that, if unexpected news gaps the prices well beyond your intended exit point (like in the BIIB and ELN examples above), you may lose two, three or four times your intended amount. If that initial risk amount was only 1%, then the bigger loss, while not pleasant, is also not catastrophic.

Seasoned investors and traders may go as high as 2% risk, but then only for proven strategies. In the classic book Market Wizards, many of the legendary investors state that risking more than 2% on a trade is just gun slinging. (For more on this book, see the "Tips & Tricks" section below.)

Follow your rules and the intent of those rules. If your trading plan stipulates that you will only risk 1% per position, don't bend the rules so that you can risk more. It's easy to rationalize that buying more options on the same stock - but at a different strike price or different expiration month - is really a different position. Or if you like your position in a semiconductor stock but are already at your 1% risk maximum, you can easily talk yourself into buying three other semiconductor stocks. But if Intel unexpectedly announces that it will cut capital expenditures in half next quarter, the result will be the same for all of your semiconductor stocks - in general, they will move down as a sector.

Don't wait for a costly lesson to come along and grab your attention. Practice good position sizing techniques now for sustainable profits.

Today's TU Tips & Tricks

  • The book I mentioned above called Market Wizards: Interviews with Top Trades, by Jack Schwager, is a great read. You'll fall in love with the concepts of Ed Seykota, read a concise summary of Dr. Van K. Tharp's thoughts on trading psychology, and find some key threads that run through the conversations from all of these great minds. You can find the book here.
  • While you're picking up a copy of Market Wizards, go ahead and grab a copy of New Market Wizards, also by Schwager. It is an extension of the first book with more great interviews and, as an added bonus, has a summary of the lessons from all the interviews as a last chapter. For the book, click here.
  • Advanced Trader's U: If you'd like to dig into position sizing more, here are two great resources: The first is the book that I co-authored with Van Tharp and Steve Sjuggerud call Safe Strategies for Financial Freedom. It has some simple and complete sections on position sizing. You can find a copy by clicking here. For detailed insight into the nuts and bolts of how to do position sizing for many different needs, check out Van Tharp's excellent resource: "Special Report on Money Management."

Great trading,

D.R.

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