| Size Matters |
Investing is not about avoiding risk but avoiding it. To that end,
an investor should always be reluctant to commit too much capital to a single position.
Not because you don't believe in your flair for stock picking, but because sometimes the
best way to manage risk is not to take it in the first place.
Just for a moment look beyond the golden principle of “When you buy a stock, it is
the company's management you should be focused on” and extend it to focus on
management of your own portfolio. And while security selection gets all the headlines,
it's money management — namely position size — that ultimately has the biggest
impact on your bottom line.
You want to buy the dips? Or stocks making new 52-week lows? Go ahead, knock yourself out.
But please do yourself a favor and keep the stakes small. Most people won't hesitate to
drop 15% or more of their portfolio into a single name at a single price. That isn't just
dangerous, it's insane. A good portfolio should be structured like a good life. Everything
in moderation.
So remember Size kills. Position size is what did in Nick Lesson, the kid whose huge bets
took down Barings, England's oldest merchant bank. No matter what sort of analysis an
investor uses, nothing will wreck a portfolio faster than putting too much of your assets
in one particular holding. Despite the misconception that traders love to take big rolls
of the dice, the truth is that large positions grow large, they don't start out that way.
So while there is nothing wrong with having a position appreciate to become 15% of your
portfolio, putting that much in at once is suicidal.
One way of overcoming this size problem is to diversify your portfolio. Diversify by asset
class, by trading not just in stocks, but also in bonds, commodities and other
noncorrelated investments. Diversify by time by having both short-term and long-term time
horizons for particular plays. Diversify by sector, stock and, in this case, price. Put
15% or more of your portfolio into one stock at one price, and you are throwing a lot of
chips on a weak hand. In this dangerous scenario, often even the normal volatility of the
security will be enough to throw traders out of otherwise smart positions. No matter how
good your research is, not every stock you pick will be a winner. Most people have losing
trades all the time. It's OK to have losing trades — the trick is not to have them be
the biggest positions in your portfolio. Your biggest open trade should be a winning
stock, not a losing one.
Sit on losers and you'll suffer an opportunity cost. But sit on (or add to) big losers,
and you'll just plain suffer. It's this lack of trade management that has been the
downfall of many an investor. Large positions are even more lethal when, as is often the
case, they're accompanied by an inordinate amount of leverage. When you've financed those
large positions by buying stock on margin, you've got to be right or get out.
A classic example of this suffering can be seen in the mutual funds who went crazy over
the Ice sector. They bought at highs and bought with total disregard to the sectoral
promises they had made as well as the basics of minimising risk by diversifying scrips and
sectors. It was betting your all on one horse. And as the horse slowed down, your position
was so huge that you couldn’t get out by leading the price to fall even lower. Where
people were reading about Infosys heading towards the Rs 10,000 mark, today you have it at
below Rs 5000, but fund managers are still stuck at the startospheric levels they bought
it at.
So, always keep your exposure to a sector, a stock well below the 10%-15% range and
diversify across instruments, so that you can weather the shocks that might be in store
for you. The best way to avoid getting hurt is to avoid putting yourself in a position to
be hurt. So, keep your positions small and risk manageable. A good defense is your best
offense.
Aru Srivastava
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