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POSITION SIZING IS MORE IMPORTANT THAN STOP LOSSES!

POSITION SIZING IS MORE IMPORTANT THAN STOP LOSSES!

Every trader/investor likes to talk about stop losses. Stop losses are crucial for short-term traders but not so much for longer-term investors. Undoubtedly they are vital, but they aren’t the most important thing. Do you know what is most important? Position sizing is.Think about a portfolio manager with billions of dollars in Assets Under Management. They can’t afford to keep getting stopped out of the markets left and right. If the fund is large enough, they could move the entire market by a few percentage points.Not only that, but some of the more distinguished opportunities require an investor to withstand pain before making serious money. If you owned shares in Apple after the 1980 IPO, would you want to be stopped out of your entire position because it moved against you a few percentage points? The upside potential over the long term is too massive to think in terms of short-term unrealized losses. 

 

BRIDGEWATERS PORTFOLIO CONSTRUCTION

Hedge fund managers use stop losses to an extent, but the emphasis is more on position sizing. To illustrate this point, we will briefly examine legendary investor Ray Dalio’s hedge fund. The firm manages $223 Billion, spread out across +700 positions. The larger position only makes up five percent of their portfolio, and the average position size is less than half a percent. No one position can make or break Bridgewater. Not only that, but the dollar amount per position is too large for a stop loss. Market makers will make contrarian plays against large whales. Large firms are far more susceptible to market manipulation tactics.

FOLLOWING OUR PLAN IS HARD

One of the primary reasons position sizing is so important is because of our inability to follow our directions. Everybody has a plan and of course, they believe that they will follow the plan. Why else would they even bother to make plans in the first place? So why don’t we always follow the plan? Most often, the issue is that they have too much exposure in the position, and they are too invested in the outcome. Additionally, sometimes a change in plans is necessary. Frequently the real problem is not having a plan that allows for flexibility.

FLEXIBILITY IS A KEY CONSIDERATION

When your position sizing is large, you have to be willing to set narrow stop losses. The problem with setting stop losses too tight is you need to have flexibility around your ideas. That type of risk management strategy works better when you are a strictly technical trader with no fundamental viewpoints. Fundamental investors are trying to find data that the rest of the market isn’t fairly pricing. Longer-term investors need to be willing to risk a much larger percentage of the account.

Rarely do positions ever go in the direction that I want right away. Especially when I’m looking for information that isn’t priced in. It takes time for the rest of the market to come to the same realization. If our stops are too rigid, we will often get stopped out of some of our best ideas, and we might not find a better price in the future. With these strategies, it’s difficult to predict the tops and bottoms.

WHAT DETERMINES POSITION SIZING?

How well do I know the company? If I know the company inside and out, I’m typically able to quantify a good portion of the risk going into the position. Holding onto a steep loss might make sense if I know something that market doesn’t. Most of the time the answer is no. 

How consistent are the financials? When you look at the companies revenue growth rates, gross margins, & net margins, how much deviation do you see from the average across years? Higher variation creates less certainty around the accuracy of our cash flow models. Accurate models allow for transparency in the investment valuation process. 

Do I know something that the market doesn’t? Most of the time the answer to this is no. Now and then, I find ideas that I have extreme levels of conviction. What gives me confidence in my analysis? A companies ability to generate cash flow is the most critical concern. 

How much standard deviation does the name have? When I look at the stock’s average performance, I also like to look at standard deviation. Standard deviation tells you how close each of the data points is to the average. My rule of thumb is that if the standard deviation exceeds 20 percent, I limit the position allocation to less than 10 percent of my portfolio. Generally, my positions are rarely larger than 5 percent. 

Can I easily create a no-cost options hedge? You can create a no-cost option hedge if the options provide enough liquidity. This is one of the major things I look at when evaluating how large I want my position size to be.

Industry exposure: How diversified is the companies revenue? How many different industries are they exposed to, and what percentage of their revenue does each one make up? Also, look at what countries they may have exposure to.  

How long do I need to hold the position? Sometimes I feel confident in my idea, but I anticipate a prolonged period of underperformance. Longer hold periods require investors to consider opportunity costs. Proper position sizing allows us to pursue other ideas simultaneously. Additionally, it enables us to have more room for error. Position entry and exits should rarely be binary. Investors should seek to gain exposure in small gradual increments. 

How much liquidity does the market provide me? Liquidity is what allows us to be able to get out of our positions. Position sizing sometimes needs to be limited because of the size of the market. 

Can I create an income around that position? The ability to generate income is an important component of position sizing. There are two main ways to create an income around a core position. You can either collect dividends or sell options. If I can create stable income via options, I’m more likely to have a more sizable position. The income is pretty small for any individual trade, but it adds up over time. 

How much beta/alpha does it have to the broader market? Correlation to the broader markets can create risk in your portfolio depending on your strategy. Some of my portfolios I intentionally look for exposure into 

What is the stock’s ATR? ATR stands for Average True Range, and it’s a measure of how much the stock moves daily. Stocks that have larger daily movement should have lower portfolio exposure. 

How much data do I have? Data is a major aspect of decision-making. The less fundamental data I have, the more I’ll be able to make calculated decisions. When I’m looking at the trading stock, and I see that it’s a new IPO, I have to account for the fact that I have enough data to determine the stocks tendencies. 

 

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