When you're just getting started in investing, it's easy to get tripped up by things that you hadn't thought of or didn't think were important. One thing that is often overlooked is 'position sizing', or how much of your investment money goes into each business.
Position sizing
I have a good friend (let's call him Bill) who kindly agreed to share an investing mistake he made recently that illustrates this point well:
Bill's strategy of buying shares was to wait until he had 'enough money' got excited about the pile of cash he'd saved, and then put it all in one company. Not too long ago he purchased a big chunk of RCG Corporation Ltd (ASX: RCG) in one hit – more than 20% of his portfolio.
RCG shares subsequently dropped from ~$1.40ish to today's prices of $1.01, a 38% decline. Yet with 20% of his portfolio in this one company, that one fluctuation removed 8% of my friend's capital in one hit. Had he chosen a more ordinary 5% or 10% position, the losses would have been a manageable 2% or 4% respectively – not so significant, and likely forgotten in a few months' time.
How to know what size position you should have?
An investing axiom is that you should adjust your positions based on their risk – higher risks should be a smaller part of your portfolio and vice versa. Much has been written on this in intermediate to advanced investing texts – but if you're new to investing, you won't have read those.
If you don't have the skills yet to confidently say company XYZ has less risk or more potential than company ABC (and the ability to point to reasons why this is so), then one straightforward way to ameliorate some risk is by simply making sure all your positions are a similar size and that you own an adequate number of companies — thus spreading the risk.
Here are 3 simple ways to think about your position size:
- If you aim to own an equal sized position in 20 companies (20-30 is a good number) then by definition you can't have more than 5% in any one company. If any one of those 20 companies falls by 50%, the impact on your portfolio will be 2.5% or less.
- If you have a larger portfolio, you can reduce risk by splitting your purchases into halves or even thirds, and buying them 6 months to a year apart. If you're not sure what a company's value is (especially if you're new to investing) then spreading out the purchases over time can give you a better chance at buying the company at a fair price.
- Spread your companies out by industry. For instance, if you aim to own 20 companies and four of them are Commonwealth Bank of Australia (ASX: CBA), Westpac Banking Corp (ASX: WBC), National Australia Bank Ltd. (ASX: NAB) and Australia and New Zealand Banking Group (ASX: ANZ), that puts 20% of your portfolio in the banking industry and quadruples the size of the hit you'll take if the banking industry suffers. It can be safer to spread that risk, with less exposure to any one sector as a whole.
You can reduce your risk significantly by using these simple strategies.
