What Is The Maximum Position Size In My Diversified Stock Portfolio?

One of the most important aspects of investing is to think about risk, and one of the most important ways to manage risk is through diversification. Humility demands that we always acknowledge that we could be wrong about any individual stock, or any individual prediction. So we should diversify our portfolios to ensure that a single mistake cannot deal an overly harmful blow, on its own.

Why Do So Many People Think 12 Stocks Provide Diversification?

The apocryphal wisdom when it comes to diversification is that 12 – 18 stocks provide 90% of the benefit of diversification, though this is based on theoretical studies based on equal position sized and a random selection of stocks. Personally, I do not select stocks randomly but thematically, choosing companies that are concentrated in a variety of industries, but mostly limited to education, healthcare, software, finance and heavy industry maintenance. I skip huge numbers of industries, and my stock picks are not random. The same may be true for you.

However, if we run with 18 as a good number to provide diversification, then that implies a position size of around 5.5%. Because it is likely that my stocks are clustered around certain thematics, I would argue that the natural number of stocks I’d need for diversification is actually higher. So for me, I use 3% as my “standard default position size”.

Can A Strong Business Justify Higher Position Sizing?

As a growth investor, my strategy is to look for multi-year, multi-baggers. Even though I’ve made profits from many different businesses, my top 5 most profitable stocks account for some 70% of my total gains. Invariably, I sold those stocks too early, and took profits when I should have held. But I also allowed those positions to exceed my standard position size of 3%, almost 100% of the time. In fact, in one case, I allowed one of my position sizes, Pro Medicus, to exceed 30%, for many months on end. That decision has been crucial to achieving extraordinary returns, and I’m unlikely to be able to replicate my past returns going forward, unless I’m willing to let my winners run.

Having said that, I think letting a position get that big is very risky, and I would generally encourage people not to do that. I guess I have broken my own rules, and I’d do it again, but arguably that is wrong, and I would not do it easily.

Of course, I would never actually buy a 30% position in a stock, and I would generally never even let a position get that big. But at the same time, I think it’s important to think about the specific situation, when it comes to considering how quickly one should trim the winners. After all, it is usually a mistake to trim the flowers and water the weeds, because that amounts to allocating more capital to investments where the market is suggesting I am wrong, while removing capital from investments where the market is indicating I am right!

When Should I Worry That A Single Stock Is Too Much Of My Portfolio?

As per the apocryphal rule above (12 – 18 companies) I would generally allow most businesses to get to about 5.5%, before I’d worry about the negative impact they have on diversification, unless they were very similar to another business I own. In that case, I might consider two stocks a single exposure, for diversification analysis.

For example, I own shares in both Diversa and Sequoia, which are very similar businesses. Combined, they are about 7.5% position, so I am cautious about adding to either, even though they are individually both well below 5.5%.

I would take into account a number of factors about whether I would tolerate an oversized position, or not. Here are the major qualitative questions I ask:

Is it in an essential industry such as healthcare, supermarkets, utilities, mission critical software or other non-discretionary items?

Is it profitable and almost certain to remain profitable?

Does it have a healthy balance sheet?

Am I very confident that management are both honest and competent?

Are there long term tailwinds that make time the friend, and not the enemy, of this business?

Finally, valuation is also extremely relevant to position sizing. Even though I would be willing to hold on to a long term investment even if I think the market has got ahead of itself, and the price is too high, I would generally not want to hold a massively oversize position in a stock that I think is super overvalued. So the last question is:

Where is the share price relative to an attractive buying price based on my valuation?

In order for a stock to become more than 5.5% of my portfolio, I would generally have to answer all the qualitative questions in the affirmative. Alternatively, it might score 3 or 4 out of 5 on the quality questions, but have a share price sitting at an attractive buying price, or below.

In order for a stock to become more than about 8% of my portfolio, it would really need to score 4 out of 5 on the qualitative questions, if the stock was cheap, or 5 out of 5 if it traded notably above my buy price valuation.

Generally in order for a stock to be above 11% position size, I would generally need it to score 5 out of 5 on the qualitative questions and trade not no more than 80% – 90% of my attractive buy price.

Only one stock has ever been more than 20% of my portfolio and that really was exceptional. For much of that time I was slowly selling shares.

Both Price And Quality Matter When It Comes To Risk Management In A Portfolio

That leads me to my last point. If I think a stock I own is lower quality, I would sell it more quickly if it became a large position. However, if a stock is higher quality, I would be more likely to sell it bit by bit over time, in order to trim the position slowly. In both cases, I would consider how much higher the price was than my valuation. For a low quality business, I’d probably sell it at or around my valuation. For a higher quality business, I’d probably be slower to sell in the hope that the market would bid the stock higher.

I would also consider the sociological factors, which is really about asking “who will buy this stock off me and how much will they pay?” For example, where a stock is quite large but has not yet entered the ASX 200, I am often hesitant to sell much if I think it will soon enter the ASX 200. The reason for this is that entry into the ASX 200 is likely to trigger automatic buying from index funds, which can push the stock higher. Therefore, in some instances, sociological analysis would influence my position sizing.

What Is My Default Position Size For A Single Stock?

As a general rule of thumb, I think of 3% as my default position size, 5.5% as my default maximum size and 11% as a maximum in most cases. Obviously, I’m willing to go well above 11% but it would be very rare and I would be surprised if I would ever have such conviction in more than one stock at a time.

Finally, one also has to think of the overall portfolio. If you have one stock with 11% position sizing, then 25 stocks all around 3% – 4%, you would still have a fairly diversified portfolio. However, if you had 9 stocks each being around 11%, then you would not have a diversified portfolio. Also, I would question how you could have followed 9 companies so well as to understand them sufficiently well to have such a large position. I would say that would be difficult unless you were full time investing for years.

Please remember that these are personal reflections about markets by an author. This article should not form the basis of an investment decision. It is an investment diary valuable only for the cognitive process it demonstrates. We do not provide financial advice, and any commentary is general in nature. Please read our disclaimer.

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