Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
We recently had a good discussion in our member’s forum about portfolio management and position sizing. What we found is whether your investment strategy is taking hundreds of positions or just a handful you can find an investment guru that has done well over the course of time. Walter
We recently had a good discussion in our member’s forum about portfolio management and position sizing. What we found is whether your investment strategy is taking hundreds of positions or just a handful you can find an investment guru that has done well over the course of time. Walter Schloss invested in an average of 100 positions. If you don’t know Schloss, he is one of the icons of value investing. For the 45 years Schloss managed his fund, he crushed the S&P 500 by producing returns of 15.3 percent versus 10 percent for the S&P 500. On the other hand, when Warren Buffett was managing “smaller” amounts of capital he had as few as five positions making up 97% of his portfolio, and one investment making up 50% of his portfolio. Bob Auer who we interviewed here on MicroCapClub, uses a purely quantitative approach, and holds an average of 90-120 stocks in the portfolio. This strategy allowed him to grow $100,000 to $30 million from 1986 – 2007 without any new capital added during this timeframe.
In 1977 Elton and Gruber worked out an empirical example of the gains from diversification. Their approach was to consider a population of 3,290 securities available for possible inclusion in a portfolio, and to consider the average risk over all possible randomly chosen n-asset portfolios with equal amounts held in each included asset, for various values of n. Their results are summarized in the following table. It can be seen that most of the gains from diversification come for 30 positions or less. (source)
In the end, I don’t think there is a right or wrong answer as your position sizing likely fits your investing strategy, personality, and also the amount of capital you have to invest. Investors that use a purely quantitative approach can manage many positions at once. Those that use a more qualitative approach normally can’t manage more than a 10-20 positions.
Here are some thoughts on this subject by some of our members:
I’m in the process of working my way down from 15-20 companies down to a maximum of 10. I buy up to a 3% position based on an initial look. After determining either the CFO or CEO is accessible and liking what I’ve learned after more thorough dd I then buy 5-8%. After seeing at least one earnings report and having had a chance to go through every possible negative scenario I can imagine and eliminating it, I then buy up to 12% at cost.
Buffett talks in code sometimes and what he says is so insanely simple that most investors tend to gloss right over his best advice. I read an article one time that said that Buffett was constantly asked to write a book about his investing style, but he won’t because he has already shared what he knows in various speeches, interviews and shareholder letters. The fact is that if people took the time to piece together his different quotes and allegories, it spells it all out right there for you.
Here’s my takeaway from Warren:
Buffet said a few years ago that he “Guaranteed” that he could make 50%+ annually in the markets in present day if he was a smaller individual investor because its easier to find information these days and the best opportunities exist in small companies. If you pay attention to how he invested when he was younger, in terms of company size and portfolio concentration, I think it’s fairly obvious how he would do it. He’d probably be right here on MicroCap Club finding a few of the best companies every year or so and betting heavily on them!
My philosophy has tried to mirror Buffet’s younger years. I find underfollowed (Micro Cap) companies and get to know the business. Because of the (at times) extremely irrational price behaviors of these stocks, I take my time forming a position at a reasonable margin of safety to my valuation. And I bet big in terms of the % of my portfolio. It makes more sense to me to be concentrated because the central tenet to my investing style is to “know thy company”. I just don’t have time to get to know/keep up with a dozen companies in the manner that would make me comfortable. I have 3-5 positions that make up 80% of my portfolio plus a few multi-baggers (mature companies) that I keep a small amount of stock around just to remind me of the value of “sitting tight” as Livermore would say.
In regards to Schloss or “quantitative value” guys like Greenblatt’s Magic Formula. Since you don’t get to know the business investing like them, you need to have more diversification for smoothing tendencies. Everyone knows that the numbers don’t tell the whole story but over a larger sample size they will outperform if you have the right strategy. Just a small out-performance with one of these investing styles will compound over a long period of time to deliver extremely great results in comparison to a standard index. This makes sense for most people who want to beat the market but not put a ton of time into it. However, I think if you want extreme returns, it takes concentration. It’s definitely higher risk/higher reward, but I think that’s what most of us are after if we’re on here anyways…
Lastly, ever since I read “Fortune’s Formula” about the Kelly Formula, I’ve been obsessed with it. The investing applications of it really describe what Munger and Buffett did early on, although they claim to not know of the formula (although they admit it describes what they did to a T). Anyways, my allocation of money within my 3-5 main positions is based on this “formula”.
My philosophy may be somewhat different than others here. My investing heroes are Graham and Schloss and I am probably closest to Schloss in how I invest. I would not say I am a microcap investor per se, I simply will buy what’s cheap and hold it until it isn’t. I’ll buy just about anything, whether it’s an illiquid, unlisted nanocap or a well known megacap. My only requirement is that it be cheap. Usually of course what I buy is in the nano and microcap area, but I don’t put any labels on myself in that regard.
In addition, I will take small positions in things and usually have around 100 positions at any onetime. That’s not a target or a goal, just how it tends to work out. I’ll go a bit larger in size if the opportunity arises, but that’s more rare for me. I think that investors can often be put into one of 2 categories. There are those who view their investments as art and those who view their investments as inventory. The former often like their investments to be beautiful. They want to hang them on the wall and admire them. At a 10,000 foot level many of these folks are avid followers of Buffett. They want to buy and hold and just admire the beauty (although of course the reality is that other than a handful of positions Buffett doesn’t actually hold in that manner, but I digress). On the other hand, there are those, like me, who view their investments as inventory. I liken what I do to stocking a grocery store. You have everything from filet mignon to packs of gum. I don’t care what it is as long as it will make me money. Likewise, I don’t subscribe to the view that a smaller position doesn’t move the needle. Many of these positions can be purchased within an hour or two (or less) of work. It’s like the gum or diet coke in a store. Stock it, sell it, wash, rinse and repeat. I’d do that all day long if possible.
I am primarily a quantitative based investor. I let the numbers tell me a story. One thing that I am not is someone who simply buys off a screen. So while I do prefer low p/b for example I would never buy anything because a screen says to do so. It’s simply a means of finding the right pond to fish in. For those older timers out there, one of my favorite pieces on investing is the one on Tweedy Browne in John Train’s Money Masters in the Ben Graham section. This was in the late 70s and Tweedy Browne at the time probably had $50 mil AUM and were much different than the run of the mill value guys they are today buying MSFT and talking about their moat. Then they would buy just about anything that met their quantitative parameters (they had around 900-1000 positions) and would purchase in positions as low as $50-200. They would hold until someone wanted to pay “full price” for it.
For me, portfolio management is all about “it depends”. I may hold upwards to 15 issues, but they may be spread over 5-8 LT holds and other swing trades. I do enter a position and then ladder in to increase the % port. At one time in 2013 the port was 40% in one issue, and I started to ladder out. At this time, with the general market iffiness, I am more cautious and thus shifting the port to higher volume issues that can be exited if necessary. So in my mind, one develops a strategy that suits them.
In discussions with another member about this same topic, he also implied that “it depends” and that it may be a number of technical and emotional items that he uses to determine port balance. Should you have a high ownership in a very thinly traded issue? Does the potential risk/loss damage your port? Should you own a biotech? etc.
Everyone has a different approach and none should be applied or taken “because, that’s what he does” – it needs to support personal needs, goals, and emotions.
It is quite clear though that people tend to sell winners and hold losers – and that psychology is written about broadly. By setting up a set of rules for yourself, one can act without emotion. E.g. if any one holding is showing red more than a $$ amount, SELL – regardless; if you own a winner, add more as it advances and set stops along the way to assure gains; if you have individual stock loses in any timeframe (say a month) of more than $x, then take yourself out; if your port declines by greater than X% sell remaining and reassess. IMO port management and control is mostly about goals balanced by money management/risk management.
I love the topic of diversification and position sizing and wanted to add my two cents. Diversification has its place and benefits, but probably not for anyone involved in these forums. A friend of mine recently asked what stock I liked to buy, hold and forget for the next twenty years and i told him to just buy SPY. If you’re trying to be ignorant about your investments, diversification is great.
Warren Buffett — “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
I previously worked in a brokerage office and I can tell you diversification is also great at doing two things.
Its a lot easier for a broker to justify a losing position in GLD when its a “Hedge”. Its also a lot easier to convince a client to own 30 stocks when they need a small, mid and large cap stock in 10 different sectors.
I’m a big believer of a concentrated portfolio 4 – 8 investments. I believe the more time you spend doing this, the more concentrated positions you should have. If you’re doing this full time, its makes no sense not to allocate to your very best 5 ideas. Yeah, its risky and it takes guts, but real money is made when you have your large position become a multi-bagger. I also believe to have an edge in this game, its a full time job to really follow and understand a dozen companies.
I like to have 3 tiers of positions: medium term trading, long term confident, and long+short term no-brainer.
Medium term stocks are ones that I have good faith in their long term prospects, but I’m much more confident that they are undervalued in the short term. Usually I believe they can have strong runs, and will sell if they go parabolic. I look for at least +100% price target, and will either wait until a run or sell if something about my valuation changes. A position is usually 3-6% of my portfolio. I would like to have 2-3 of these.
Long term holds are companies that I think have successful models, good management and financials, and I’m willing to see the position through in the long term. I’ll probably take profits over 100%, but I’ll hold at least half until either it becomes cleary overvalued, or something material changes about the long-term prospects. I know I’ve found one of these when it no longer feels like I’m purchasing stock, rather becoming a part owner of a company. I need to feel like I could sell my friends and family on the product/service, not the stock. I initialize a position with 10-20% of the portfolio. I have 2 of these right now.
Long/Short term no brainers are basically a combination of those two, where I like a company long-term and I think it’s extremely undervalued in the short term as well, such that it could easily run. It’s when there is no foreseen downside but a huge list of upside, and a high probability of good performance in the next immediate quarters. I know I’ve found one of these when I feel like I want to buy as much as possible. I’ll look for a run close to fair value and sell half, and the rest becomes a long-term hold. A long-term hold can also become a no-brainer if it falls enough. I’ll put 30-40% into it, but I have gone higher. Only 1 of these.
I don’t ever want to go over ten positions. You may be able to track more than 10 stocks, but I don’t feel like you can pay close attention to more than 10 companies. My ideal is 5-6
I also have a principle of “Always wish you bought more, and always sell too much” If I have a gut target allocation in a stock, I try to hold myself back from buying the full amount at that level. If I have an amount mentally allocated to sell at a certain level, I’ll sell a little more than that.
I find this helps prevent me from getting caught up emotionally with the movement of the stock. On the upside, I find the regret of not having as much as I initially wanted counteracts the euphoria of being right and making money. On the other hand, if my medium term stock goes down, thank goodness I bought less than I wanted to. And if my long-term stock goes down, fantastic, I get to average down and complete my allocation.
Although, I’m a naturally emotional guy, so I need this. Maybe if I was stone cold, it would be unnecessary.
I don’t think position sizing is static and among the stories attributed to Livermore is that he approached trading with a military mind. He would send out patrols as he called the trades to test the market, and if he sustained losses he considered it a small price to pay for the accurate feel it gave him of the market. One can see an example of this approach in how plays in football in the first half that may gain little or even lose yardage are used to set up winning plays in the second half.
I agree with those who would limit their coverage to a half dozen or so, with room to change and drop as situations change. There is an ebb and flow to pricing for stocks and much money can be made knowing how to play those cycles, One of the virtues of sending out patrols is that it gives real data about what is going on in the market and in your mind. Just like it is very difficult to learn from a paper portfolio because emotions are not involved, the same holds true for trading to test the market as opposed to just watching the prices and the trend.
One of the first things I learned when I went into the market full time was that money is just a commodity, and if you are in the market it is a position and fungible, so if the price of your stocks goes up or down, you don’t treat the up or down like it was taken or given to you, it is just fluctuations in the value of your inventory and there can be intangible capital in what you have learned from your losses. It is the same psychology that comes into play knowing that you must not give in to the fiction that you have not succeeded if you have not bought at the low and sold at the high.
I find that knowing when to sell is the most difficult thing to do. The psychology is so strong to wait until a stock has peaked and then you are forced into selling on the way done when volume is working against you. The alternative is to sell on the way up and that can create recriminations later that you sold too soon, which is often the case if you are playing with scared money. At the end of the day you have to stay in your comfort zone and know whether you are a singles or long ball hitter.
Last but not least about what comes to mind about position and sizing is Soros’ rule that supposedly he forgave you if you were wrong, but if you were right he expected you to have bet big.
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Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
Nicolai Tangen is the CEO of Norges Bank Investment Management, Norway's $1.4 trillion sovereign wealth fund.
Dilution is the subtle erosion of ownership. This hidden, persistent addition of new supply of shares leaves shareholders with less and less of the company’s value. Dilution, like inflation, is a silent killer of returns.