Reduce Risk By Managing Your Position Size

Sooner or later, we all invest in a stock that tanks. A company with sound fundamentals today may be down 70% a year from now. It happens, so it pays to be prepared for an event like this.

What is your exit strategy if one of your favorite stocks starts to fall? Let’s say it’s down 20% over the next couple of months, and then another 20% after that. This is when investors start to get nervous, and they want to bail. After all, the market has cast its vote, right?

If a company is still fundamentally sound, I always urge investors to hang in there. I have multiple personal experiences of a stock dropping by 40% only to then turn into a 10-bagger (i.e., become worth 10 times what I paid for it). In order to realize that you have to be prepared to ride out volatility.

I think it’s fine, regardless of your investment time horizon, to have volatile positions in your portfolio. You just don’t want your entire portfolio to be volatile if your time horizon is short.

The way to manage volatility and still sleep at night is to keep individual position sizing small. When I buy a company, I intend to hold it through whatever volatility may come. I only sell a company if I believe the material outlook has changed for that company or its industry. After all, you haven’t really taken the loss until you sell and lock it in. (If you sell at year-end for tax loss harvesting, that’s another perfectly acceptable reason to take a loss).

Occasionally I have taken losses of as much as 70% to 90% on some individual holdings. But if you keep such holdings to only 2% to 5% of your portfolio, which is my recommendation, an individual wipe out like that won’t destroy your portfolio.

It is far less likely, if you are managing diversification and volatility, that all of your positions will experience huge declines.

Thus, if you have a $100,000 portfolio, I recommend you take positions of no greater than $5,000 each (but preferably about half that). If you wanted to fully invest that account in equities, that means no fewer than 20 positions. I know that seems like a lot of positions for a portfolio that size, so let me clarify something.

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If you have a mutual fund, or other funds outside of this (like a separate retirement account), that can reduce the need for such small position sizing.

For example, let’s say that in addition to that $100,000 portfolio, you have a diversified 401k that’s worth $500,000. In that case, you could feel free to take larger positions in the $100,000 portfolio, because it doesn’t represent the sum total of your overall portfolio. Or if part of that $100,000 portfolio is in mutual funds, larger positions are okay because the mutual funds are already diversified. Consequently, I might have $50,000 in two mutual funds, and then 10 positions at $5,000 each.

To make this rule as broadly applicable as possible, just make sure that if any one position got wiped out, it doesn’t make a huge overall impact on your portfolio. You never want one position to be able to have more than a 5% total impact on your overall investments. When you keep positions small, it will decrease your desire to panic sell during a correction.

That is a key to successful investing in the long term. Don’t panic sell and lock in your losses. Keep your positions small and ride out the volatility if the company and sector are still fundamentally sound.

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