Position Sizing to Manage Risk
Position sizing is a critical money risk management concept. The best risk management plan is diversification that includes asset allocation rules. These rules will be the framework from which the first steps toward position sizing decisions are made. As an example, here are the diversification rules of my risk management plan:
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Never Put More Than 5% in Any One Stock
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Never Put More Than 15% in any One ETF or Mutual Fund
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Never Put More Than 25% in any One Industry.
What is Position Sizing?
Position sizing is simply the size of an individual investment position within a particular portfolio. This can be expressed as a monetary amount or as a percentage of the portfolio. Investors can choose to purchase or sell their position all at once or scale in and scale out.
What is Scale In?
Scale in is a process of purchasing positions in smaller increments than your ultimate position size might be. It can be used as a form of dollar cost averaging, although there are many variations and strategies for scale in.
What is Scale Out?
Scale out is a process of selling portions of a position in increments rather than selling the entire position at once.
Both Scale in and Scale out are an admission by the investor that trying to time tops and bottoms is impossible. No one can consistently buy at the bottom and sell at the top. Therefore an investor may want to manage money by taking the more conservative approach of scaling in and scaling out of positions. Just like it makes sense to not put all your eggs in one basket to manage risk; it might make sense to not be all in or all out of an investment.
Money risk management is about taking measured and appropriate risks when circumstances and valuations are favorable. I normally try to avoid transactions of less than 1% position; not only for convenience and costs, but because over diversification is harmful. There is no reason to purchase positions of less than 1%. So for individual stocks my position size is going to be between 1% and 5% because my risk management rule requires me to sell a portion of a stock that appreciates beyond 5% of my portfolio.
“Extreme” Dollar Cost Averaging
Extreme Dollar Cost Averaging is not a trading strategy but a long term value investing strategy. I especially like to employ this strategy when purchasing blue-chip dividend paying stocks.
When an investment achieves my price target I try to take a small enough position that I can increase my position 2 or 3 times if the stock becomes a bigger bargain. Let say XYZ reaches my target price so I buy a 1.1% position. If XYZ falls 10% my position size is now 1.0%. I re-evaluate the company; if nothing has fundamentally changed I can now buy XYZ for 10% less. Now I might choose to buy a 1.2% position (more that the first purchase) because it is a better bargain. Now my position size is 2.2%. If XYZ falls another 10% my position falls to 2.0%. I re-evaluate the company; if nothing has fundamentally changed I can buy more. This time I might buy a 1.3% position, increasing my position size to 3.3% of my portfolio. See how this works? Not only am I dollar cost averaging, but I purchased more in dollar amount each time, at better and better prices. That is why I call it “extreme” dollar cost averaging!
The same strategy can be used as a stock moves higher. Sell a small increment and then sell larger portions if the stock continues to move higher. This reduces the risk of holding too much of a particular stock as it moves higher and higher. It is a risk management strategy.
Risk management is an important part of the way you manage money. You can use position size, scaling in, and scaling out to manage risk within your target asset allocation.
| AAAMP Blog by Ken Faulkenberry | |
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Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record. |
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