Gen. Robert H. Barrow, Commandant of the Marine Corps, noted in 1980 that…
Amateurs talk about tactics, but professionals study logistics.
Similarly, in the investing world, “stock selection” is talked and written about ad nauseum by amateurs, but in my opinion, “position sizing” represents the more crucial component of investing success.
This is why an academic paper by a hedge fund research firm, Novus, caught my eye. The paper studies the impact of position sizing on “alpha” (excess returns compared to a standardized risk / return benchmark) generated by hedge fund managers. Novus is releasing its findings in three parts, but here are some of the key takeaways from Part 1.
- Hedge fund managers, on average, make money on position sizing. Said differently, managers, on average, out perform an “equal-weight” version of their portfolios.
- There are wide performance gaps between managers who demonstrate position sizing skills. The top 2.5% of these managers (by outperformance) added 10% incremental alpha through sizing! The group of managers that outperformed an equal-weight version of themselves added on average 2.77% return through sizing skills. That’s a real difference for those managers who are good.
- The effects of position sizing vary from year to year. For example in in 2011, sizing generated over 1.5% additional return while in 2010 and 2012, the effects of sizing were negative.
Interestingly, the large outperformance noted in the second bullet point above was due in large part to a manager’s willingness to “double down” when a stock was suffering an unrealized loss. The study points out that doubling down can be thought of as a signal that the manager is confident enough in an investment’s valuation to accept career risk. As we discuss in the IOI 101 training course, career risk is a much more acute concern to “agents” (i.e., financial intermediaries) than risks that a “principal” (i.e., the owner of capital) typically cares about (e.g., absolute and relative return in the long run).
For IOI’s intelligent investors, position sizing is a key “structuring” element in any investment decision. It is based on not only what else is currently in one’s portfolio but also on the “merit” of the investment in question. Is this a speculative punt (smaller allocation) or a well researched idea with a significant margin of safety (potentially larger allocation)? The answers to this question are also about the leverage being taken on as well as the opportunity cost of the investment.
Bottom line, position sizing should be well thought through at the beginning of an investment and managed accordingly throughout the holding period.
For more on this, please contact IOI with questions on the form below or join us as a member for one of our Structuring Workshops, where we work together with our members to appropriately structure an investment in a company we have researched.