If a trader has a concentrated portfolio and things go his way, he can gain big in a shorter time. The first rule is not to put an entire account into just one stock because that would mean too much risk. On the other hand, in order to accomplish super performance, diversifying the portfolio too much is disadvantageous.
Diversification is a trick used to allocate investments among different securities to curb losses when the security declines to ensure overall smoothing of short term volatility. However, the goal should be optimal position sizing. The position size should be defined by how much equity one stands to lose if a trade goes against him.
Instead of unscientifically picking a number, the maximum risk should not be more than 1.25 to 2.5% of equity on a single trade. Either the stop must be moved or the position size. One or the other must be modified to sustain the correct amount of risk.
The key is to find a balance between a favourable position size and a stop that allows the stock’s price to deviate normally without clogging off the trade.
If a trader sticks to Mark’s position sizing guidelines below, he will never take on too much risk per position.
- 1.25–2.5% risk of total equity
- Maximum stop of 10%
- Average losses should not be more than 5–6%
- Never take a position larger than 50%
- Aim for optimal 20–25% positions in the best names
- Total of 10 to 12 stocks (16 to 20 for larger professional portfolios)
Depending on the portfolio size and risk, there should be 4 to 8 stocks in the portfolio. For larger portfolios, there must be 10 to 12 stocks. This will ensure adequate diversification.
If four out of six stocks are doing well and two are performing poorly, then it’s perhaps time to reallocate the capital. In such a situation, position size must be reduced in those two dull stocks instead of completely dumping them.
While selling a few stocks and reallocating the capital into others, a trader doesn't want to keep himself over diversified. According to the author, it is not diversification but “di-worsification.”
Large numbers of stocks are difficult to track and the position also becomes small for each stock. This weakens the possibility to get super performance out of a really big winner.
It’s better to learn how to concentrate the buys in the best names strictly at the right time and then safeguard yourself with the help of reasonable stop-loss order.
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