Last Updated on Dec 21, 2023 by Harshit Singh
Determining how to allocate your portfolio is a critical aspect of investing. Many beginners grapple with how much to invest and divide those funds to minimise risks and maximise returns. While the former question may be distinct, the answer to the latter revolves around diversification. Diversification is a key strategy to achieve higher returns while managing risk effectively – it’s like the old saying goes, “Don’t put all your eggs in one basket.”
This strategy involves spreading investments across different asset classes and considering various factors to determine the right allocation for an investor’s needs. For instance, a retiree without a steady income might prefer a more significant portion of their wealth in fixed-income securities. On the other hand, a young professional starting their career might choose to invest their earnings from an internship in equities. The idea is that diversification is personalised to fit each individual’s circumstances and goals.
When considering diversification, two challenges often emerge. Either investors make the mistake of under-diversifying the portfolio or going to the opposite extreme of over-diversification.
So in the above portfolio, even though the investor made great returns in the majority of the scripts, then, too, the portfolio has generated negative returns because a huge chunk of the portfolio was invested in a stock that performed poorly.
Now, on the other hand, if you look at this portfolio, even though the investor made some great returns in a lot of scripts but due to investing minuscule weightages of the portfolio, those returns did not impact the portfolio significantly, and the overall returns were about 7%.
So, this is the problem we are going to address: What are some of the key factors one can look at when deciding on position sizing?
1: Individual Risk and Return Expectations – Investing is a very subjective topic, and it will always differ for different individuals. By considering an individual’s risk appetite, one needs to decide what the position size of the portfolio will be.
For reference – My grandfather wouldn’t load up his portfolio with volatile, high-growth SME companies; he would have some mature businesses giving him a high dividend yield.
2: Investment Bucketing – This refers to categorising stocks based on specific criteria like risk level growth potential or market cap. This practice helps in position sizing by allowing investors to allocate capital efficiently.
For Reference – A company having a huge growth potential will generally have higher downside risk, too, so an investor can choose to have a lower or higher weightage in that company based on individual risk appetite.
3: Correlation among asset classes – It’s important to avoid holding stocks with strong positive correlations for extended periods. If an adverse event affects a particular sector, having a diversified portfolio helps safeguard the rest of your investments from being overly impacted.
For Reference – If your portfolio is loaded up with real estate and infrastructure companies, then in a rising interest rate cycle, you might end up with many problems as both sectors are affected by interest rates.
4: Liquidity – The liquidity of stocks significantly influences portfolio weighting decisions. When a stock has low liquidity, there should be a limit to its allocation within the portfolio. Going beyond this limit could make buying or selling the stock at fair prices challenging. This issue isn’t solely confined to large institutions; even individual investors might encounter difficulty when attempting to exit or enter positions in stocks affected by bulk transactions. Such scenarios can lead to increased volatility, making it less straightforward to achieve fair prices for trades.
For Reference – Suppose you’ve invested in a low-liquidity stock and held it for two years, enjoying substantial returns. However, when faced with a family emergency requiring you to sell, you find the stock’s price under pressure due to institutional selling. This creates a situation where selling at unfavourable prices becomes unavoidable.
5: Scale Up Allocation with Deeper Business Understanding – As you grasp the granular details of a business and find it compelling, consider starting with a smaller position. As your insights deepen and your understanding grows, you can gradually increase your investment. With the company’s progress, your confidence and comprehension also elevate significantly.
For Reference – A business you’ve followed for 2 or 3 years likely offers a deeper understanding compared to one you’ve recently studied.
In conclusion, effective position sizing is an important aspect of successful investing. It’s not merely about the amount of capital invested but a strategic alignment with individual risk tolerance, return expectations, and market conditions. Remember, position sizing isn’t a one-size-fits-all approach. It’s a personalised strategy that evolves with an investor’s knowledge, circumstances, and the ever-changing market dynamics.
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