Portfolio management is an important skill which all investors should possess. A poorly structured portfolio could end up giving the investor sleepless nights and cause anxiety. Therefore, portfolio management is a skill which any investor should strive to hone over time.
Position sizing is one of the first considerations an investor should have when constructing a portfolio. In a nutshell, this involves determining the maximum and minimum position sizes one should have within the portfolio. If you feel a company is growing very rapidly but is facing significant risks, then size the position smaller. Conversely, if a company has very stable operating characteristics and is generating good cash flow, on top of paying a stable dividend, the investor may wish to take on a larger position in it. An example of a range could be anything from 1% to 3% for a small position, while a larger one could be anything from 8% to 10%.
The total number of positions within the portfolio would give some indication of how large a position should be, on average. An example would be a portfolio with 20 positions and 10% cash – the remaining 90% would be split equally among the 20 positions to yield an average position size of 4.5% (90% divided by 20).
Each company would have a risk-reward ratio assigned to it, and the investor decides on his allocation based on the level of this ratio. There is no right or wrong answer for this, and everyone would have to take his or her personal preferences into account when sizing their positions.
The danger in sizing a position too large is that it may result in a significant drag on portfolio performance should the company report poor earnings, resulting in a crash in the share price. However, this could also work against the investor – if the position is sized too small but goes on to double or triple, it may not result in a perceivable positive impact on the portfolio.
In a follow-up article, I shall move on to the next attribute of portfolio construction, which is the number of positions one should own. [Editor’s note: Part 2 and 3 of this series has been published. They can be found here and here.]
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.