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POWER OF POSITION SIZING

PREPARED BY: Chris StanfordĀ 

DATE: 09/20/21

Stop losses are often a topic of discussion among traders and investors, but position sizing holds greater importance. While stop losses are crucial for short-term traders, they may not be as critical for longer-term investors. Let’s explore why position sizing is the key factor to consider in trading and investing.

Position sizing plays a crucial role in ensuring traders and investors can stick to their plans. Overexposure in a position and excessive emotional attachment to outcomes often lead to deviating from the original plan. Having flexible position sizing allows for adapting to changing circumstances while still maintaining risk management principles.

Rigidity in setting tight stop losses can limit flexibility when it comes to executing investment ideas. Fundamental investors who consider market inefficiencies and long-term value need the flexibility to withstand short-term volatility. Predicting market tops and bottoms is challenging, and inflexible stop losses can lead to prematurely exiting potentially profitable positions.

LIQUIDITY CONSIDERATIONS

Sometimes, selling positions at the desired stop price may be difficult without incurring significant bid-ask spreads. Implementing a rigid standard position size for every trade might not be ideal. Multi-strategy investors, in particular, need to define criteria based on various portfolios and account for liquidity differences.

Large-scale portfolio managers handling billions of dollars in Assets Under Management cannot afford to be frequently stopped out of the markets. With substantial funds, their trades could potentially impact the market itself. Therefore, position sizing becomes vital in managing such portfolios effectively. Lucrative investment opportunities require enduring short-term losses before reaping significant gains.

For example, if you had invested in Apple after its 1980 IPO, a few percentage points of temporary decline should not have caused you to exit the entire position. Considering the massive upside potential in the long run, focusing on short-term unrealized losses becomes less important.

RAY DALIO AS A CASE STUDY

Hedge fund managers like Ray Dalio prioritize position sizing over stop losses. Bridgewater, with $223 billion under management, maintains a well-diversified portfolio with many positions, where no single position dominates. Larger position sizes may not be suitable for stop losses, as they can attract market manipulation and hinder effective risk management.

DETERMINING POSITION SIZING

When determining position sizes, consider the following factors:

Familiarity with the Company: A deep understanding of the company helps quantify the associated risks and potential rewards, providing confidence in holding positions even during temporary losses.

Consistency of Financials: Consistent financials, including revenue growth rates, gross margins, and net margins, contribute to accurate cash flow modeling and investment valuation.

Unique Insights: Occasional extreme conviction in an idea arises when you possess unique information that the broader market may not be aware of, particularly concerning a company’s cash flow generation capability.

Standard Deviation: Analyze the stock’s average performance and standard deviation. Higher standard deviation may warrant smaller position allocations to mitigate risk, especially if it exceeds 20% and the portfolio’s risk tolerance.

Options Hedging: Evaluate the possibility of creating a no-cost options hedge based on options liquidity. This can influence the size of the position.

Industry Exposure: Assess the company’s revenue diversification across different industries and countries to manage industry-specific risks.

Holding Period: Anticipating prolonged periods of underperformance requires considering opportunity costs. Proper position sizing allows for pursuing other ideas simultaneously and accommodating potential errors.

Market Liquidity: Evaluate the liquidity of the market to ensure the ability to exit positions effectively.

Income Generation: Position sizing can be influenced by the potential to generate income through dividends or options strategies. Stable income streams



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