My previous article explored the different approaches to position sizing. Now I want to discuss my preferred approach to the task and five elements I consider. You will likely have your own approach that works for you, but there is value in thinking about what we base these decisions on.
To start, I lean towards concentrating. I bet heavily on a few of my best ideas but at the same time, I still hold quite a “long tail” of different stocks at any given time -- about 104 positions at last count. That includes shorts. On the short side, I tend to diversify more widely because theoretically, they all represent an unlimited potential loss. Some shorts also serve to offset exposure through an M&A event. You could argue, in these instances, that the long and short leg together make up one actual position. That would take my number of positions somewhat below 100.
I practice and work hard at differentiating between the amount of alpha each idea should generate. Although I never buy a stock I don't believe will offer a better risk-reward compared to the market, there is a much larger number of them where my conviction is modest compared to the number of “sure-things.” Usually, I take the following criteria in consideration when deciding on size.
1. Attractiveness on a risk-reward basis
The major consideration in position sizing is the risk-reward profile. The more attractive the trade is compared to other trades, the more I want to allocate here. My top idea tends to receive an allocation that is significantly larger than others.
Currently, I’ve allocated roughly 25% of net asset value of the fund I manage to Scully Royalty (SRL, Financial) (that I wrote up recently for the GuruFocus Value Idea Contest). It didn’t start out at that size, but the investment appreciated 188% since the time I first invested. I did add to the position over time, as more information became available and my insight improved, but it also increased in size organically. I’m comfortable maintaining it at this size for three reasons: risk/reward, catalyst (exposed to this risk for a limited amount of time), strong balance sheet.
So far, it has been extremely rare for me to start a position at a size like this. In 15 years of investing, I only once sized an investment like that in my private portfolio.
But risk-reward by itself isn’t everything. Sometimes I find trades that I believe have a terrific risk-reward profile, but I ask myself questions like: What if I made an important mistake in analysis? What if I’m missing something important? What are the odds I’m investing on the basis of made-up numbers? How do I expect its price to behave and what is the maximum downside? I’ll expand further on some of these questions below. My main point is that even if you have an amazing risk-reward, in general, I favor taking a cautious approach to sizing.
2. What does the downside look like if things go horribly wrong
There are investments or trades with terrific risk-reward profiles that have horrific downsides. You can imagine a biotech firm with a single product in development that fails an important trial could depreciate close to 100% in a flash.
Long ideas do not usually cost you more than 100% unless you use recourse leverage. Short ideas instead theoretically have unlimited downside. It may sound a bit simplistic, but this has me more careful with short ideas. As the Financial Times put it aptly in their beautiful portrait of the famous Porsche (POAHY, Financial) short squeeze:
"Perhaps another lesson is that panic runs both ways. Often we associate a ruinous market event with things collapsing, such as Carillion last year, but the Volkswagen short-squeeze shows fear can propel securities upwards as well, and far beyond the 100 per cent downside on 'long' investments."
On the flipside, something like a great balance sheet may influence me to size a position somewhat larger. If there's a lot of net cash per share, the downside could be limited, and I'll be comfortable taking a larger bite.
3. Expected share price movement
In finance what is referred to as risk is actually volatility. Volatility, of course, is a measure of share price movement either way. That’s not how I assess risk, and the prospect of volatility does not scare me away from an attractive risk-reward. However, I do consider how much volatility I can expect. Historical volatility can play a role in that judgment. Very high volatility in a thinly traded microcap may convince me to size smaller than I otherwise would given the risk-reward.
If I’m investing in a merger-arbitrage that will close more than 90% of the time with little price volatility I’m looking at that 5-10% of the time it doesn’t close. What will the share price do then? I’ll base position size not so much on the price movement I expect to take place, but I heavily take into consideration the worst-case scenario.
4. Time of exposure (is there a catalyst near?)
If an investment idea has a catalyst or it plays out over a limited time frame, I’m inclined to size it somewhat larger because the risk is less open-ended in terms of time of exposure. I still strongly consider the downside risk from a deal blow-up but consider general recession risk, market risk and Black Swan risks to be somewhat less of a threat.
5. Available capital
It may sound stupid, but what often plays into a decision is available capital. Especially on the ideas in my portfolio that I think are great but not fantastic. I size these picks on the lower end of the range I'm comfortable with. These are much more often getting replaced as a better opportunity emerges. I sacrifice a little bit of return by diversifying outside of my high-conviction picks. But this helps to more easily survive when I inevitably get hurt by one of my high conviction ideas taking a wrong turn.
Unfortunately, higher turnover leads to higher transaction costs. If a new investment idea is clearly better than the risk-reward offered by the market but not clearly better than my other ideas, I’m not thrilled to sell something else to add it. If I do not have a great deal of cash, this can impact the sizing. I may size it smaller than I otherwise would.
Disclosure: Long Scully Royalty.
Read more here:Ă‚
Ray Dalio: Paradigm Shift Upon Us, Buy GoldÂ
Portfolio Strategy: Diversification Versus ConcentrationÂ
Richard Pzena Interviews Joel Greenblatt at Benjamin Graham ConferenceÂ
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