Position Sizing
and why you should listen to your heart
This post makes the following assumptions:
(1) We are emotional creatures to varying degrees
(2) We cannot help but be influenced by our emotions (biases)
(3) We can only recognize the triggers and change our environment to shield us from them
Introduction
The subject of position sizing has been talked and written about by virtually everyone. I will not repeat their opinions here. What becomes clear from reading and listening to others discuss position sizing is that there is no single answer that suits everyone. Position sizing is truly a personal decision, and it should be based on how you deal with your own emotions. The opinions of others, even the masters, can only ever be a guide.
When a company has made it onto my buy list, it has passed all screens and filters. The only thing left to do is wait for a price, which gives me a margin of safety to my conservative estimate of intrinsic value. I think this will sound quite familiar to most value investors. When the time comes where Mr. Market offers me the right price, I must decide how much I want to invest. At this point I have used different approaches all of which have taught me some valuable lessons about my emotions.
I have started positions by allocating various percentage amounts in the past. Some I started out with a high allocation right away and some I started out with a small allocation and continued buying over the course of the next month. Both strategies felt decidedly different and had their own unique advantages and disadvantages. In this post I will discuss how the different approaches affected me emotionally and what these emotions have taught me about future bet sizes.
Committing 5% in the same trade
I have pulled the trigger before and committed 5% of my net worth in one trade. This had the advantage that I no longer needed to be concerned with the price movements of the investment. I knew due to the size that I will not increase the bet in the forseeable future. This made me feel at piece, calm and gave me time to focus on reading. The disadvantage was, that while reading and researching I happened to stumble upon the price by accident. This is the bad aspect of the WSJ and certain publications I read via the browser. The price was down over 10% from my entry point. This gave me a feeling of loss. I told myself: “I should have dollar cost averaged into the position, just likely Buffett, Munger and others have said, instead of going all in, in one day. “ I decided to switch my approach.
Dollar Cost averaging into the position
The next time I decided to try a different approach. I purchased chunks of 1%, 1.5% and 2% over the course of a month. I did this for two different investments and had totally different experiences. With the first it was a big success in the sense that I continued buying into the decline. That made me feel good, because it was the exact reason why I decided to try it. Therefore, I felt a sense of control over the final purchase price I would pay.
The second investment however did the opposite. I bought my first small position and then the price went up. Since it continued to go up, I had a worse feeling than I did when I just bought 5% all at ones. In addition to the feeling of loss, I constantly felt a need to check the price. I decided to stick to my strategy, not act on this fear of having missed the low and I continued to purchase in small increments. I ended up averaging out just above my first initial position in terms of price. But the ride to get there was one of checking prices on my phone after waking up. That was a red flag.
I made my final incremental purchase and stopped looking at the market altogether for a few weeks. That felt much better, much more comfortable, and much more in sync with how I want to live my life while investing. Then after two weeks the real lesson of all this hit home. When I checked prices again the price was 10% down!
A tale of three approaches
There is no way of knowing where prices are going to move. When I purchased everything in one go, I may have missed the bottom, but I felt much better the days following my investment. When I dollar cost averaged as the price declined, I felt amazing, naturally, but when I dollar cost average and the price went up, it was the worst emotional experience so far (in investing that is). Then there is the issue of deciding over what period one should dollar cost average. A week? A Month? A year? At this point it seems that the answer is: it depends on how you feel. But there are more emotions needing to be considered.
You really know a company after you own it.
The feeling of ownership did influence my actions a lot. After I made my 5% bet in the same trade and decided moved on, I felt drawn to knowing more. The combination of that feeling combined with the feeling of being “free of the price movements” made me want to investigate my company more without a feeling of worry. This combination was truly great.
On the one hand my newly found motivation made me realize a few things that I didn’t see before. Or at least it let me see them in a new light. In this case my additional findings seemed probable to be positive. But they could have also been negative. Yet, throughout my investigating it became difficult to avoid the price. When I run a thorough scuttlebutt it is virtually impossible to tune out the price, because it simply shows up in too many places. But the price could be up, or it could be down, both creating a different emotional state. I simply will not know which scenario I will encounter and therefore my initial sizing strategy must be independent of my findings and the price changes I may see.
Analysis of my emotions
What were the positives and negatives in my bet sizing approaches and how could I possible harness the power of the positives, while shielding myself as best as possible from the negatives?
I know that the feeling of having ownership was a powerful positive force. I know that the feeling of freedom by not checking prices was a positive force. I know that the fear of paying too much when making an immediate large bet was a negative force (when prices went down after). And I know that the fear of missing out while dollar cost averaging into an increasing position was a negative force as well. How to harness the upside without exposing myself to too much downside?
New information can change my investment thesis one way or the other. If I begin finding evidence that my thesis is playing out, I will feel good about my investment. If it is up, I will feel validated and if it is down, I can buy more. I learned the hard way that I need to be patient with Mr. Market, because sometimes he will offer you the same attractive bargains again, just a few months later. I would only be able to take advantage of it, if I haven’t already used a large initial position.
The suitable approach for me
There’s a strong argument to be made for investing an initial smaller amount (1% to 3%) after a company lands on the buy list:
(1) The ownership motivation gained from buying is a powerful positive force that I want to harness.
(2) I give a little to my emotional side by eliminating the fear of missing out completely and putting some skin in the game
(3) If there is a total loss of capital it is small
This will inevitably lead me to dollar cost averaging if I want to increase my position. However, I can protect myself from my emotional state described above by creating a procedure for adding to the position:
(1) Step away from the investment and let the subconsciousness do some work without worrying
(2) Actively try and disprove the thesis. If the thesis plays out positively, slowly increase your positions in times when Mr. Market is kind. If the thesis doesn’t play out, let the small amount ride, or cut my losses.
Conclusion
My conclusion is my introduction. Bet sizing cannot be taught and there is no one size fits all answer. It is too much of an emotional experience to do it one way or another. What works for Charlie Munger, may not work for me. I will say that the process I used to arrive at my approach may work for others.
(1) Identify your emotions in varying scenarios
(2) Figure out what triggered them and why
(3) Change your environment (approach, tools, procedures) to shield you from the bad and promote the positive