What is Position Sizing?
Investors always face the dilemma of how many portions of their portfolio should be allocated to certain stocks. Investors generally allocate a high percentage of their portfolio to the stocks in which they have high conviction. But allocating our capital based on our conviction itself is not a good strategy. It is very much interesting to know that, the position sizing on stocks can decide the fate of the portfolio. For example, consider the stocks that we own in our portfolio grows 100x but sadly we have allocated only 1% of our portfolio to this stock then, the significant gain in the value of the stock may not completely reflect in our portfolio. That’s why position sizing is very important to maximize the portfolio payoff.
As an investor, maximizing our portfolio payoff over time requires to do two things
Find situations where we have an analytical edge
Allocate the appropriate amount of capital when we do have an edge.
Most of the investors spend their time in gaining an edge but very few understand how to allocate capital to maximize their long-term wealth (position sizing).
It is very much interesting to know that, two portfolios having same stocks and even bought on the same date can give two completely different portfolio return over a period of time and the reason for this is position sizing. It is very important for investors to have a certain edge in the market and edge not only refers to having more information than others but rather having a different viewpoint than others. If we don’t have any edge, we may end up by doing what everyone is doing, which may lead us to poor returns.
Position sizing example
Assume you participate in a coin toss game where heads pay Rs 2 and tails costs Rs 1. You start with a Rs 100 bankroll and you play 50 rounds. What betting strategy will allow you to achieve the greatest probability of having more money at the end of the 50th round? How much money you are willing to bet in each round? If you bet all your money Rs 100 and if you go wrong, you would not be able to play the next round, so what is the best strategy to maximize our money?
First, we should find what is our edge. “Edge” in this game refers to the expected payoff and odds refers to the capital that we get if we win.
So, an edge is Rs 0.5 and the odds are Rs 2(the amount that we get if we win the game). Now we have to find the amount that we must allocate in each round so that we can maximize our wealth.
So by allocating 25% (Edge/Odds) of your money in each round, we can maximize our wealth in the long term. One of the main things about this strategy is that the risk of ruin is minimum. This strategy of capital allocation is often referred to as the Kelly formula. Investors can use this simple Kelly formula to their capital allocation process.
Capital allocation skill is one of the most valuable skills that investors can develop and intelligent capital allocation needs to have an edge and able to calculate the odds of winning.
The key takeaway for investors
- Edge is the ultimate success key
Having an edge requires understanding the market’s perspective. One way for investors to think about edge is finding situations where the stock’s rate of return is likely to be higher than what the market anticipates. If we think that, certain stocks is going to give a higher return than the market expects, then we gain an edge and we can allocate a higher percentage of our portfolio to gain a higher return if our thesis materializes.
- Implementing Kelly criteria is physiologically hard – investors must digest the volatility
Kelly formula helps investors in how much to bet when we have an edge to improve long term success but the volatility in achieving the long-term wealth is high. Applying Kelly formula may sometime have huge volatility in the payoff. This high volatility will make investors become loss averse and not follow the Kelly formula.
Position sizing is the most important factor that dictates the success of the portfolio. Investor’s time and efforts should flow constantly to gain an edge and capitalizing of the edge with proper position sizing.