The WheelieDealer approach to position sizing: Part 1

As I see it, appropriate Position Sizing is vital to create a diversified portfolio which provides the overall level of Risk that is acceptable to the individual investor. As I have stated to the point where you are all fed up with it, I see Success in the Stockmarket comes from careful avoidance of mistakes – don’t crash the Plane.

Let me emphasise the point about a level of risk that is acceptable to the investor – it is vital that you think about what kind of risk level overall you are prepared to tolerate. This is not simple at all to determine – and I would hazard a guess that most investors over-estimate their tolerance to risk. Many people say they are comfortable as a High Risk investor – but when the stock market falls 15% they poo their pants. This is a good Signal that you should heed over your investing career – if you find you need to wear brown trousers a lot then you are taking too much risk and you must reduce it – this can be by decreasing money in the stock market (increasing cash); or maybe by focusing more on Large Cap stocks (e.g. Blue Chip FTSE100) as opposed to tiddlers (dodgy AIM shares); or perhaps by changing your strategy from a growth focussed approach to more of an Income generating High Divvy Yield bias.

Many of you probably realise that Risk and Reward are intrinsically linked – simply put, Higher Risk should give Higher Reward (or High Risk = High Expected Returns). Higher Risk also means Higher Volatility – i.e. A High Risk portfolio will have wilder swings as the markets in general surge higher or lower – in the jargon, it is Higher Beta. The theory is that despite the wild swings over time, in the long run a Higher Risk portfolio will outperform a Lower or Medium Risk portfolio.

So, not is it simply a case of deciding on your perceived Level of Risk and therefore logically your perceived tolerance to volatility, it is also vital to establish your Target Level of Annual Returns. Again, for clarity, you can see it as follows for the Stockmarket (this is not necessarily your Risk / Return Level for your Total Wealth (Cash, Property, Stamps, Vintage Cars etc included):

  • High Risk – Target 20% Annual Return
  • Medium Risk – Target 15% Annual Return
  • Low Risk – Target 10% Annual Return.

Please appreciate that this is my own subjective and utterly unscientific sense of Risk / Return – you might want to amend slightly for your own purposes. However, the principle of such a list is sound and can be applied at your Total Wealth Level, to a Lower Risk Income Portfolio or maybe to a concentrated AIM only portfolio – up to you.

This list is very helpful (easy for me to say, I invented the flipping thing !!) and can help determine appropriate understanding of both Risk and Return. For example, it is clearly daft to say you want 20% Annual Returns but to say at the same time that you are a Low Risk investor.

To help determine your Risk / Reward levels, it might help to reread or read for the first time my Blog entry from 21st October on the Rule of 72.

Before you commit any money to the Stockmarket, I suggest you should address Risk / Reward as I have outlined above and write it down in your own personal ‘Investing Strategy’ document. No doubt I will be scribbling about such a planning document in a future Blog. This is a vital first step if you are serious about exploiting the Stockmarket in a Safe and Successful manner.

Position Sizing across various different Portfolios

When talking about Position Sizing I guess most people think of it as “how much cash should I put in each stock?” but you can also view it from a higher level as “how do I spread my Total Wealth across various different Portfolio Pots?”.

For clarity, when I say Total Wealth I pretty much mean what it says on the tin – i.e. All your worldly goods. For a considerable number of people most of their Total Wealth will be tied up in Property – the house they live in. In addition, you can also think of a Pension Fund as part of your Wealth – however, you need to think carefully because although a Pension is part of your Wealth, it is extremely illiquid because you cannot use it until you retire – and that could be many years off (particularly now as the Government keeps raising the Retirement Age !!).

Another factor in your ‘Wealth’ that is mostly overlooked is your own Human Capital – i.e. if you have another 30 years of work ahead of you for instance, you could take on a higher level of Risk than perhaps someone with only 5 years to retirement should take. For the younger person, if a higher risk approach leads to big falls in their investments in the early years, they have time to recover the drop. Someone close to retirement would be rather silly to go betting all their cash on the latest Hot AIM mining stocks.

To illustrate the above points, my Wealth is spread across the following pots in roughly the proportions outlined (for more details on my Portfolios please view the Current Portfolio tab of this website):

  • Long Spreadbet Exposure – 25%
  • Trading Portfolio – 30%
  • Unit Trusts – 10%
  • Corporate Bonds – 0%
  • Income Portfolio – 5%
  • With Profits Bonds – 10%
  • Human Capital – 0% (ok not totally true as I do get a small income stream from some other sources)
  • Property – 0% (I had a share in a couple of houses which were sold this year)
  • Government Bonds – 0%
  • Other – 5%
  • Cash – 15%.

I think the numbers add up to 100% !!

I have ordered them in descending levels of risk as I judge them. It is probably a worthwhile exercise for you to draw up a similar list – especially if you have a big pile of cash to invest. I have included Bonds to assist in drawing up a list although I do not hold any – a With Profits Bond is a different animal in my view.

I am reasonably happy with this spread but my intention is to gradually increase the money devoted to my Income Portfolio (by shoving the maximum ISA allowance in each year to take advantage of Tax Breaks on divvy income) and with hopefully some growth in the Income Portfolio.

I feel my Spreadbet Long Exposure is at the top end of what I am comfortable with – if I can boost my Income Portfolio proportion, the Spreadbet Long Exposure should come down as a proportion if I keep the Absolute Monetary value of my Long Spreadbet Exposure the same over time, although I may flex this up and down a bit depending on the markets. As an example, in reality at this moment in time, my Long Spreadbet Exposure is effectively Zero as I have a counterbalancing Short FTSE100 position. I will address how I use Spreadbets in a future Blog Post but it is not crucial as I would rather address some key points for starting on an Investment Career first off. Spreadbets are best avoided until you have a lot of experience in my view – they are potentially Personal Bankruptcy Tools.

This % split across Asset Classes is not set in stone and can be varied over time – but such decisions should be incremental and you must think long and hard before any changes. A change in proportions could arise from your stage of life – you may want safer assets nearing retirement or maybe as a result of Economic Factors – recessions throw up Stock investing opportunities and in Bull Markets you should gradually increase the proportion in Cash so you are prepared for a Bear Market drop and have cash to buy bargains.

Another important consideration is Rebalancing. I suggest you should review your overall Asset Allocations once every year – I normally do a proper assessment at the end of each calendar year, however, in practice I am regularly thinking about the split. At the end of the Review Period, you will find that some Assets have done well, some have done rubbish and some have done nothing. You may decide to move some of the outperforming Asset into other Assets and may for instance, buy more of the Underperformer. Thought and care are vital here though.

Article written by @wheeliedealer

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