Rule #2: Position Sizing Pays, Not Your Ideas
Trading Rules Series
Popularized by Dr. Van Tharp, Position Sizing is a concept that drives most of a trader's annual PnL. We focus 99% of our energy on our entries, exits, and idea generation. Yet, Position Sizing tends to be a very weak skill among portfolio managers. We have published Improving Trading Skill: Part 4, providing a process for measuring your position sizing skill.
The application of this framework to hundreds of portfolios yields the following broad observations:
Slightly over half of the portfolios analyzed reflect a negative sizing skill. This means that, in aggregate, the managers' active sizing decisions underperform a passive equal active share rule. Granular analyses enable these managers to improve deliberately.
Despite the adage that encourages investors to “feed their winners and starve their losers,” professional managers seem to prefer doing the opposite. They more commonly add to positions that have an unrealized loss while hesitating to build up younger positions that start to take off. Sadly, these contrarian activities usually don’t work, as too few underperforming positions successfully rebound, and too many winners continue to run undersized.
Ervolini, Michael A.. Managing Equity Portfolios: A Behavioral Approach to Improving Skills and Investment Processes (The MIT Press) (p. 44). The MIT Press. Kindle Edition.
Now think about this. We can take the same trades but have different results due to our Position Sizing. This idea on its own might seem like a dumb insight. But, consider that over half of managers have negative sizing skills, and managers tend to add to their losers. What if your lagging performance has nothing to do with your idea generation or trade selection and everything to do with how you size your positions?
We also tend to lump position sizing in with our risk management. Yes, position sizing and risk management work together, but that is a massive mistake. A portfolio manager needs a framework to determine his allocation or risk on a particular trade. A checklist needs to be formed, taking in different variables and weighing them. Create a personalized position sizing algorithm.
A lot of traders like to use conviction to size their positions. To those traders:
Do you know if you have sizing skills?
Do you know the trade criteria/factors that define your biggest winning trades?
Have you calibrated your conviction with a basic ranking system and post analysis or results vs. conviction score?
Conviction can be a variable in position sizing, but as a single variable, it's disastrous. Remember, the odds are you're average, and the studies state that we struggle with position sizing.
Take this concept seriously, and your trading results will drastically improve. Create a set of rules that allow you to put the most money behind your most significant expected value trades and limits your losses on your lowest expectancy trades.