Despite picking a fair share of good stocks, it is still tough to generate some consistent serious alpha. Picking the right stocks and exiting them well tells You how often You win. How much You win, however, is a function of how much You bet. Some professional investors pay surprisingly little attention to their bet sizes. Below are four algorithm often practiced by professionals that can
- Four popular bet sizing algorithms used by professionals that have negative gain expectancy
- Size does matter in the markets: 1$ or 100 will have a different outcome
When it comes to bet sizing, there are only two sizes: either too much, either too little. As a professional short-seller, position sizing is mission critical. Successful positions shrink. Not only do they contribute less and less, but they also tilt exposures (net & net Beta). To add insult to injury, they become less noticeable. On the other hand, unsuccessful positions balloon. They immediately hurt. So, I have spent years studying the science of bet sizing. I sought to learn from other investment professionals. It eventually dawned upon me that Long biased people rarely ask themselves the same questions. For them, bet sizing does not have the same degree of urgency. Worse even, it became apparent that some position sizing algorithms had outright negative expectancy, or nasty side effects that they were never even aware of.
Horseman 1: Liquidity. If You can’t get out, You don’t own stuff. Stuff owns You
Getting into a position is like buying a boat, or a second house. You can do that any day of the week. Now, selling a boat is tough (been there, done that). It may take time to build a position in a stock. Time is an expensive luxury few market participants can afford when they want to liquidate.So, no matter how attractive a story may be, if you can’t exit easily, just don’t enter.
Rule 1: don’t size your positions so that they may go Hotel California on You:
“You can check-out anytime You like, but You can never leave!”, Don Henley, Hotel California
Horseman 2: High conviction: feel-good position sizing
Disclaimer: this position sizing is used by the greatest and the worst investors. The classic rationale is: “if You believe in something, then you should go big or go home”. What else is it but a feel good position sizing algorithm ? Risk is not quantified but subjectively assessed. The problem is mental accounting, or the constant emotional revisionism of the situation. Jack Welch said: “what can be measured can be improved”. If You can’t quantify your risk, then don’t expect improvement in consistent alpha generation capability.
The greatest investors also use conviction as a position sizing algorithm. The only difference is that they express conviction in units of risk. They quantify risk first and then put chips on the table according to their perception of the reward. If an idea does not pan out, risk can be parred down.
Horseman 3: Equal size: one-size-fits-all and the volatility roller coaster
This position sizing algorithm will not bring ruin, but it has negative side-effects that may prevent You from achieving your obejctives in terms of performance, attractiveness to investors and quality of life…
Equal weight is a form of laziness:
First, let’s look at the math behind equal weight. All trading systems boil down to their trading edge (Avg Win% * Win% – Avg Loss% *|Loss%|). Since all bets are equal, equal weight implicitly puts emphasis on the signal, and excludes the value of money management. In other words, stock picking has to be consistently above 50% to absorb losses and generate a profit. Unfortunately, no system works all the time. So, equal weight carries cyclicality in performance.
Ignoring volatility at the position sizing level invites volatility in the portfolio
Not all stocks have the same personality. Some are more volatile than others. For example, internet stocks tend to be much more turbulent than utilities. If all positions are sized equally, then the most volatile stocks will drive the volatility of the overall portfolio. Morality, ignoring volatility at the position sizing level will in turn invite volatility in the portfolio.
Horseman 4: Average down, martingale and the certainty of ruin
Rookie gamblers always come up with some elaborate scheme to break the casino. It is usually a variation on the theme of doubling down after each loss. They believe that the losing streak will end and they will recoup their losses. This position sizing algorithm is known as martingale. Let’s look at the math behind this algorithm
1. Adding to a losing position reduces the hit ratio
2. even if You had infinite capital, the most favourable outcome would be break-even. First, do You have infinite capital ? Second, any other outcome before the most favourable one carries an interesting probabilistic property called certainty of ruin
3. Doubling down means adding to losers. Resources have to come from somewhere, probably winning trades. Books written by successful market participants always emphasize “cut losers, ride winners”. Do You know any successful market guru who says “cut your winners, ride your losers ?”
In conclusion, there is a reason casinos have gold, marble, paintings from masters and gamblers declare bankruptcy. Double down on losers and You will go broke. One more thing about probabilities, it’s not about if, it’s about when.
Size does matter in the markets. Not paying enough attention to position sizing has consequences that range from unpleasant volatility to certainty of ruin. Position sizing is not a glamorous topic, but in highly competitive sport, every little bit of edge counts