21Jan 2016

The WheelieDealer approach to position sizing: Part 2

Yet again, I seem to be addressing what I consider to be a widely misunderstood and often badly undertaken topic.

The fact is that I see this as another vital step in controlling risk and keeping the Plane up in the air.

The simple, basic approach is to put the same amount of money into each stock you buy. This sounds great – let’s say you have £12000 and you want to have a portfolio of 12 stocks – then you put £1000 in each. This is an approach many people seem to take and it is beautifully appealing.

However, maybe there is a lurking danger. The thing to get your head around is that different stocks have different Volatilities in their prices and that some stocks are more likely to go horribly wrong in terms of bankruptcy or general Corporate Distress which can erode your money.

Remember, if a stock you hold falls 50%, you need it to go up 100% to get back to where you started. The maths are painful this way. I will be revisiting this in future blogs.

Standard Portfolio Theory that you will hear trotted out from the usual ‘experts’ will equate Volatility with Risk – a stock with a more choppy share price is seen as higher risk (higher Beta) than one that is less choppy. But there is another way of looking at this – as Long Term Investors, should we be that bothered about Volatility Risk? I am not so sure.

My argument is that the Risk I really want to avoid at all costs is Bankruptcy Risk – I do not want any of my Companies going bust – and if they do, then I want the impact on my overall portfolio to be minimal. In fact, I would even argue that Volatility in itself gets a bad rap – yes, stocks with Higher Volatilities might have a higher Bankruptcy risk, but if we assess our investments well before buying, we should be able to mitigate this Bankruptcy risk. So, having identified a great stock, the higher volatility which comes with it, might give us the opportunity to buy at a great price on a wild downswing or sell at a great price on a wild upswing.

High Volatility is often a generalised thing and not idiosyncratic to a particular Company – i.e. some high quality established businesses trade on AIM and in specific terms their own volatility should arguably be low – but they get tarred with the same brush as the rest of the AIM crud and consequently they have higher volatility than maybe they deserve.

Due to these different Risk levels for the different stocks in the simple 12 stock Portfolio, the overall risk of the Portfolio doing badly could be greatly increased. If one of the 12 goes bust then that would have a pretty nasty impact on the Portfolio – as much as 8.3% could be lost and if you are targeting returns of 10% to 15% CAGR (Compound Annual Growth Rate), you are going to need some of your other stocks to work hard to pull back the hit.

This brings me onto another related point – many investors obsess about how each individual stock in their Portfolio is doing and get themselves quite worked up about it. However, I look at this in a different way – I accept that I buy and sell quite a lot of stocks. It is inevitable that I will get many decisions wrong – I will buy bad stocks and I will sell too early and I will sell too late and buy too late etc. That is the nature of Long Term Investing. I am not particularly hung up on the performance of individual stocks – what does focus my mind is HOW THE OVERALL PORTFOLIO IS PERFORMING – that is what matters.

Many Traders and some Investors (I have half written a Blog which will be out soon on the distinction between the two) try to reduce Bankruptcy Risk (and Volatility Risk in the case of Traders) by using a Stoploss Policy. This is where you buy a stock and you put a Price Level under the stock where you will sell it even if it means you crystallizing a paper loss. A common approach is to set the stoploss about 10% to 15% below the entry price of the buy. I think there are some merits in this but I am not totally convinced. I will address this issue in detail in a future Blog Post fairly soon.

Ok, let’s get back on the topic……hopefully you can get a sense from the above that a simple Portfolio of 12 equally sized stocks might be suboptimal and maybe a Portfolio constructed differently would be superior – particularly in order to reduce Risks as we may not be using a Stoploss Policy. So, my answer (and I have used this approach for many years and I know it works) is to size your positions according to how you perceive their Risk – and in truth I am more concerned with Bankruptcy Risk than Volatility Risk.

Method to determine Position Size

How on earth can we do this? Well, it’s not maybe as hard as it seems. One way we could do it is to use the ‘Beta’ measure of Volatility – this is available on websites like ADVFN.com I suspect and I know it is on the ShareScope software which I use. However, that is a bit challenging and I have a much simpler way – I just size my positions according to which particular part of the overall market they sit in. It will be easiest for me to show you my guidelines:

AIM – 6 Units

FTSE Fledgling – 6 Units

FTSE Small Cap – 8 Units

FTSE250 – 12 Units

FTSE100 – 16 Units

Overseas Unit Trusts / Investment Trusts – 20 Units Maximum

Overseas Spreadbets – 10 Units.

At the start of every year I write a ‘Parameters / Rules’ kind of document for my Investing for the year coming – this is a great discipline and is actually dead easy to do once you have produced the first document – you just tweak it for each New Year. I used to actually write down the £‘s amounts I would put in each Market Size of Stock – but I realised that if I did the list in terms of Units then I just needed to decide on the Unit size each year.

The inherent beauty of my simple method is that smaller stocks tend to have higher Bankruptcy Risk and Higher Volatility Risk – so this is a great way of lowering Risk and it is not that hard to do.

One pleasant side effect of having more money in Larger Stocks is that they tend to have higher dividend yields. In fact, some Small Stocks have tiny or non existent divvys. This bias towards larger stocks means you get nice divvys which are a superb source of easy gains.

How can you adapt the WheelieDealer sizing method to your Portfolio?

Well, first thing is to amend my list to what you want to have – if you are an Investor who is happy with a higher level of Risk then you might want more in small stocks than I do and maybe

less in big ones; or maybe you are lower risk and want more in the biggies – up to you !!

Once you have your revised list (it might be the same – perhaps you should start with mine for the first year and see how it goes) the next step is to figure out your Unit Size. This is quite complicated – you need to decide how much money you will have in your Portfolio, how many stocks in total you wish to hold, and how many of each part of the market size you want to have.

For example, for 2014 my list is as follows for my Main Trading ISA:

10 AIM stocks

10 Small Cap and Fledgling stocks

10 FTSE250 stocks

5 FTSE100 stocks.

(I bet if you were to analyse this list I am incredibly undisciplined – however, these are guidelines and should not be rigidly applied in my view – some discretion is sensible).

With this information, you should be able to figure out what your Unit Size should be. It is a pain I know, but it really is a worthwhile exercise.

Here’s an example to help. Assume you figure out your Unit Size to be £100. This would mean your Total Exposures would be as follows if based on my table above:

AIM – 6 Units – £600 (6 units x Unit Size £100 = £600)

FTSE Fledgling – 6 Units – £600

FTSE Small Cap – 8 Units – £800

FTSE250 – 12 Units – £1200

FTSE100 – 16 Units – £1600

Overseas Unit Trusts / Investment Trusts – 20 Units Maximum – £2000

Overseas Spreadbets – 10 Units – £1000.

These are Total Exposures – so you could build these up in stages – this is my usual approach.

As an aside, any readers who have read books on the Turtle Traders may recognise a similar approach which they used for their shorter term Position Trading – where they held Positions for around 5 to 15 days or so. They sized their Positions according to the Average True Range (ATR) of a given Financial Instrument – ATR is a measure of Volatility Risk and has similarities to my simplistic method. It means they had smaller amounts of money in the more choppy trades – thus controlling the overall Account risk.

How do we use the Position Size guidelines in practice?

Nothing is very simple regarding the Stockmarket (maybe that’s why it appeals to us?) and there are several things to think about with regard to how you implement this approach on aday-to- day basis.

The first thing to appreciate is that once you have your Unit Size and you know how many hard earned Quids to put into each stock, you do not have to bang all of it into the stock straightaway. These Guidelines are for YOUR TOTAL POSITION – in practice it is nearly always best to build a stake slowly – buy half the Full Size Position and if it starts to go up, then maybe buy the other half or whatever.

This is a concept I follow on the whole – I buy a stock and then give it a few days – if it looks like momentum is on its side, then I buy more and ‘Push the Position’ as the Traders saying goes. If I buy a stock and it is a bit pathetic from the off, then I will reassess if I have got my Fundamental Analysis right or if I have made a big cock-up but I do not buy more. If it gets really cheap I might buy more however.

If you add to your ‘winners’ and don’t add to your ‘losers’, then logically over a Portfolio, you will make money. A Bulletin Board poster on ADVFN pointed this out the other day – rare to find such quality of insight on there !!!

You also need to think about these Total Position sizes over time. Say you bought 6 units in total of a great AIM stock and it goes up as you hoped it would (hey, you got lucky !!) – in fact, it’s a little cracker and doubles. So, now you have 12 units in it and it is a huge position and you must remember that AS A SHARE PRICE RISES, YOUR RISK INCREASES. The point is here that your Position Sizes can get out of kilter over time and you must Topslice to lock in profits and reduce your overall risk – yes, run your winners but do not be greedy. Remember to maintain ‘Balance’ in your portfolio.

However, you must not be too much of a Control Freak and rigidly stick by your Unit Sizes – you must use a bit of Artistic Discretion and give yourself some wiggle room – none of this should be set in stone. I often buy smaller amounts on things I think are very high risk and I will let a Small Cap stock get to quite a large position sometimes if I really think there is something of extreme quality here at a good valuation – Sprue Aegis SPRP is one in which I have grown a small stake into a pretty chunky one – but I am not selling, no way (especially after I saw that Robbie Burns, The Naked Trader, had bought some on his website today).

On a general point, you could if you like just buy AIM stocks – however, to me this is a very high risk strategy and only really top notch experienced (and already wealthy) investors should do this – the swings from year to year in small company returns can be huge and scary. You also are exposed to much more Bankruptcy Risk. My view is that a mixture of stock sizes adds to Diversification and lowers Risk – don’t crash the by now proverbial Plane…..

In fact, my approach is to run a fairly Medium Risk Portfolio with a mixture of stocks and then to use Spreadbets to Leverage up those returns and introduce risk in this manner for higher returns. No doubt I will be addressing this in a future Blog.

What if you are a Newbie Investor?

If you are just starting your first forays into the market then you will most likely have limited funds and you need to build up over time – both as you use more of your Disposable Income to build your Pot and as your Stocks hopefully bring home the bacon.

I would suggest that the smallest amount you should really put into any one stock is about £500. Any less than this and the costs of buying commission (and selling commission at the other end) and stamp duty and the Buy / Sell dealing spread will mean you need a big gain just to offset the costs of dealing.

Typical costs on £500 could be as little as about £20 to £25 which would be 4% to 5% – so you need to achieve a gain of this size just to breakeven. Obviously this effect is hugely reduced on larger sums – a trade of £5000 would have Costs of about £35 – 0.7%, a massive difference and a true Economy of Scale.

Try to stick to FTSE250 type companies and FTSE100 for your first forays – it may not seem all that exciting initially if you only have 4 stocks or so but you need to be patient and learn. As your portfolio builds you can take more risks in smaller stocks and be more adventurous – but in the early stages you cannot afford a blow up – worst case, it could scare you for life and mean you miss out on all those lovely gains to come !!!

The Advantage of Following Guidelines

I have a great example here of where I was a total pratt and nearly got my butt severely kicked.

About 3 or 4 years ago I bought some shares in Fiberweb FWEB and was utterly convinced I was gonna make a mint. I had held BBA Aviation for some years and FWEB was spun out of it and I felt I understood this business extremely well and it was stonkingly undervalued. So, ignoring any Sizing Guidelines, I proceeded to put an Insane amount of my money into it – about 10% of my Portfolio size for what was actually FTSE Small Cap stock. But it didn’t matter, because I had just piled into the Best Stock Ever in the History of the World !!!

Only problem is that I hadn’t. I bought at around 90p in several chunks and not long after all went badly wrong – the stock went as low as 35p I think and it murdered my overall results for that Calendar Year. It was touch and go but I felt it would not go bankrupt and I decided to ride it out. After a lot of stress and worry, it crawled its way slowly back to recovery and a few years later it got taken over at 105p and I had had a very lucky escape.

I really had got lucky here. It was a total screw up and I was a muppet for ignoring my own rules

so much. By all means flex the rules to allow some wiggle room for great stocks but you must not lose the plot and blindly ignore them – they are there for a reason. If I had followed my rules, I would probably have had only 3% to 4% of my Portfolio value in it and the impact would have been much less. I might also have slept better.

Article written by @wheeliedealer

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