Bull vs. Bear: Manage Risk With Position Sizing
Younger investors often ask me for investing advice. I tell them that the secret of wealth is straightforward: it requires time and patience.
Although the magic of compounding is easy to see in an Excel spreadsheet, it’s not a smooth ride. The decisions you make on that ride can have a dramatic impact on your ability to build wealth.
For example, if you try to time the market (i.e., jump in and out), you will almost certainly hurt your returns. You will only sell after your stock begins to decline and you will only buy after it begins to rise. You will clip the returns on both ends.
If you were fully invested in an S&P 500 index fund, you would have averaged nearly 10% a year over the long haul. That’s fantastic and will build a lot of wealth over time. But there were some large declines in certain years. You may have endured a 40% drop in some of those years. How can you avoid that?
How to Prepare for a Decline
I have found that the key to successful investing over time is to exercise patience and not be panicked by declines. But since declines are inevitable, how do you minimize their impact?
For a broad market or sector decline, you just have to ride them out. You need to be well-prepared in advance for the amount of decline you are able to tolerate. It is possible if you invest in an S&P 500 index fund that you could see a 40% decline in some years. If you are not prepared mentally to deal with that, you should seek less volatile stocks. But in doing so, you are likely to lower your long-term returns.
What do I mean by “less volatile?” That’s measured by a company’s beta, or how much a company’s shares move in relation to the S&P 500. Low beta stocks, such as electric utilities, will have lower downside risk (and lower moves up over time).
If you are investing in a stock with a higher relative beta, you need to be prepared for larger swings. Buying into a high beta position and then selling if it falls by 10% isn’t a sound strategy. Either buy the high beta stock and ride out the volatility, or avoid it altogether.
Having said that, people who depend on retirement income from their stocks need to protect the downside. You can accomplish this goal through position sizing.
Here is one of the most important things I will ever tell you. I take it for granted that you know this, but I can tell at times from some of the reactions that not everyone adheres to this rule:
Don’t take a position size that is large compared to your overall portfolio.
What do I mean by that? What is large? I don’t believe it’s wise to put more than 2% to 3% of your portfolio into any particular position. There will be times that a position collapses for one reason or another. Sometimes that may be via an unforeseen event, or it could be a result of fraud coming to light. All we can do is look at the available information and make a decision on whether a company meets our financial objectives.
Now, let’s assume we only have a 2% position in a company. Something happens (or maybe investor sentiment shifts) and shares fall by 30%. What do we do? Well, given that the position is small, the impact on the overall portfolio is small.
A 30% loss with a 2% position is only an impact of 0.6% on your overall portfolio. Certainly, not a reason to panic. We would decide what to do with that position based on whether the move down is due to deteriorating financials or an otherwise changed outlook (in which case we might sell it)…or whether it is an overreaction to some news unlikely to have a long-term negative impact on the bottom line (in which case we hold despite the 30% loss).
You also want to make sure your portfolio is diversified. If you are highly concentrated in a low-risk sector, your portfolio beta is low, but you are subjecting yourself to excessive sector risk. If the downside for the sector is 15%, and you have a portfolio exclusively in that sector, you may lose 15%.
A key takeaway: never sell just because a company declines. You sell because of a change in the outlook. By keeping your positions small, you take away the pressure to sell in a panic.
Panic selling is a good way to lower your long-term returns. If you do not have the stomach for large declines (which happen in the best companies), stick to low beta stocks.
Let’s re-cap the important lessons for building long-term wealth:
- Know your risk tolerance and invest accordingly. If you buy a high beta company and sell after a 10% decline, your risk tolerance suggests you stick to lower beta companies.
- Keep your eye on the long-term. Panicking because of short-term volatility will hurt your returns.
- Keep your individual positions small, so a large decline in one holding doesn’t have a large impact on your portfolio.
- Diversify across industries to lower your overall market risk.
- Stick to your plan and do not make emotional decisions about your investments. Accept that sometimes there will be decliners, but decide before you invest how much of a decline you are prepared to accept.
Never lose site of the fact that we are not gambling. We are playing the long-term odds to generate wealth and income over time. Sometimes there will be losers. That comes with the territory. But with accurate preparation and planning, we will minimize the impact of those losers on our portfolio.
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