A Lesson In Position Sizing – How You Could Lose 25% in Two Stocks and Still Have A Great Year

Let’s assume that at any single time you hold 50 high-beta positions with relatively equal capital allocation of about 2%. Your intention is to hold them for as long as their trend last. You expect some of them will remain your holdings for more than a year and others will get booted in a couple of weeks. When you get stopped in one of those positions, it will be replaced by another. You are constantly 100% invested. When you see signs of distribution in the market, you hedge by buying put options on the indexes or by shorting them. (There will be some very rare periods of extreme weakness when you own less than 50 stocks, because there are no signals in the market.)

You aim for a stop loss of approximately 6% for each position on average. You realize that some of your positions will give you a bigger than 6% loss if it happens that they gap down.

Let’s assume that it is earnings season and two of your holdings miss earnings badly and each drop 25%. What would be the overall damage to your portfolio of 50 stocks? Since each stock has a starting allocation of about 2%, a 25% drop would mean 50 basis points damage to the overall portfolio or 0.5%. In this case, two of your stocks are down 25%, which means that the total damage to your capital is 1%. Since those two have probably violated your stop losses, they are going to be replaced by other two that show promise for future appreciation. Not so bad when it is looked from this perspective, right? Your overall return and good sleep don’t depend on the performance of any one stock.

How do things look on the upside?

Let’s assume that one of your positions triples in a year. What is its impact to the overall capital return. Since each position starts with a 2% allocation, a 200% gain would mean a contribution of 4% to the overall portfolio’s return. Not so impressive when it is looked this way, isn’t it? One stock is not going to make your year.

When your position size is small, a few big winners and a few big losers don’t matter as much to the overall portfolio.

This does not mean that the overall return of your portfolio will be subpar.

Let’s assume that in any given year you have 120 winners and 80 losers. They are more than the 50 positions you constantly hold, because when a stock hits your stop loss, it is sold and replaced by another. The average size of your loser is 6%, the average size of your winner is 20%.

What is your total return?

Since each stock starts with an equal allocation of 2%, the impact of each loser will be (-6%)*2% = 0.12% or 12 basis points. The impact of each winner will be 20%*2% = 0.4% or 40 basis points.

The total impact of all losers will be 80*(-0.12%) = -9.6%
The total impact of all winners will be 120 * (0.4%) = 48%
In this case, the Total capital return is 48%-9.6% = 38.4%

We need to also account for transaction cost in such calculations. The smaller your capital, the bigger the negative impact of transaction cost. Unless you are using a broker like Interactive Brokers, which charges about $1 per transaction or Robin Hood, which promises free transactions or Motif Investing, where you could buy and update whole portfolios for $10.

You don’t need bigger concentration to achieve decent returns. You don’t need to put all your money in two or three names.

Then why some of the best performing money managers in the world use very different, much more concentrated approach?

Soros and Druckenmiller have made names for themselves by taking outsized risks and concentrating big portions of their capital into one or two ideas. When an idea works, they make a ton of money. When it doesn’t work, they lose a lot of money too, but the average size of their big winners far outweighs the average size of their losers. This is a topic I will elaborate on later this week.

The Next Big Thing

People ask too often what the next big thing is. Sometimes the next big thing is the last big thing. Some trends last a lot longer than anyone could expect or comprehend. This is why, sometimes momentum investing could be considered a contrarian approach. Staying with a powerful trend is psychologically more difficult than staying on the sidelines or shorting. Stocks like $TSLA and $PCLN are recent examples of that notion.

Financial markets are often forward-looking. Sometimes, they will go way ahead of themselves and discount a future that seems unattainable at the moment.

In the late 90s, people thought that the Internet will change everything we do. Those people were right. It just took a lot longer that most expected. In between the perception and the reality, there were two deep recessions that bankrupted a lot of companies and obliterated a lot of dreams. Those businesses that survived, thrived and brought substantial wealth to their shareholders. The stocks of those companies spent a lot of time on the 52-week high list.

Sometimes, financial markets will discount a future that will never happen, but the money that could be made while the whole discounting process lasts, is real.

Should Google, Apple and Facebook Act Like Venture Capital Firms?

A couple weeks ago, I watched an interesting presentation by Chris Dixon, who talked about risk taking, innovation and disruption:

Big companies are working hard on good ideas that look like good ideas. They want to bet on a sure thing.

Entrepreneurs are in the business of leftovers. They have to go after good ideas that seem like bad ideas to almost everyone else.

Sometimes, those good ideas that are initially perceived as bad ideas by most, turn into huge businesses:

When Google launched in 1998, they were very late to the search engine industry. At the time, search was dominated by large portals like Yahoo, which thought of search as a loss leader. Yahoo’s real business was and continues to be being a portal and putting display ads everywhere. Stickiness was considered the key to business success back then – how to make people to spend more time on your site. Google had the opposite strategy – its technology was so incredibly good at showing search results that people would immediately leave the website. Google tried to sell their technology for a million dollars to any of the big portals. The CEO of one of these large portals tried it and said: “This works too well. People are going to leave my site. Can you make it work less well.” Google had amazing technology, which was considered a very contrarian business idea. No one had any idea how they would make money at the time.

When you are so big and therefore have something significant to lose, you give priority to safety.

“You only need to get rich once”, says Warren Buffett. “If you realize this, you are going to do things very differently.”

You won’t take on big risks. This is exactly how many big companies think and operate.

Big corporations often become victims of their own success. They become lazy, complacent or prefer to play it safe, because the status quo is good enough. Founders and early employees are already rich and prefer to play more than to work. Some of them just leave to start another business. Money doesn’t have the same incentive. New bold ideas are looked with suspicion. Bureaucracy suffocates real innovation. Over time, such organizations become slow, inflexible and prime for disruption. Those that manage to survive and thrive are not shy about using their cash to make smart acquisitions and strategic investments.

Since 1988, Apple has made 54 acquisitions. Since 2001, Google has made 145. Since 2005, Facebook has made 45. Acquisitions are made to protect current positions, to grow and innovate. What about strategic investments?

I am sure that Daimler is glad that it bought a 10% stake in Tesla Motors a year before the electric car maker went public.

I am sure Yahoo’s shareholders are glad that back in the time someone was smart enough to buy a stake in Alibaba. Yahoo also owned a pre-IPO stake in Google, but it sold very early.

Google has taken things a step further and it has created a couple venture capital arms to diversify into fields it does not have the expertise to pursue personally. Many would argue that Google should not act as a VC Fund. It should not try to be an expert in everything and just give back the money to its shareholders. It is a valid argument. Google should do what is best for its shareholders and so far, its private market initiatives have been welcomed by the market. Google is giving its shareholders access to high-growing, disruptive businesses that are not available on public markets to most people.

Apple has chosen a different path. Maybe, because it has more cash that it knows what to do with. Maybe, because its leaders have realized that they should focus on what they are good at, instead of playing VC managers. Apple has chosen the old-fashioned way to handle its cash- paying dividends and buying back shares. I have nothing against this approach and I admire Apple’s relentless pursuit of being the best at only one or two things. It is part of Steve Jobs’ legacy:

People think focus means saying yes to the thing you’ve got to focus on. But that’s not what it means at all. It means saying no to the hundred other good ideas that there are. You have to pick carefully. I’m actually as proud of the things we haven’t done as the things I have done. Innovation is saying no to 1,000 things.

I can’t help, but wonder if the market will give Apple higher valuation if they follow Google’s example and also create a venture capital arm. They have insights about the mobile industry that very few have. They could make so many strategic investments that would end up benefiting its shareholders.

In the meantime, Facebook is doing everything they can to make sure that they are the next Facebook.

In 2012, FB acquired Instagram – it paid $1bn in cash for 30 million users or $33 per user. At the time, Facebook was ridiculed for spending so much money on a company with zero revenue. Today, Instagram has 180 million users and mobile accounts for more than half of Facebook’s revenue. Instagram is considered one of FB’s most valuable assets.

Last week, Facebook spent $19 billion to acquire WhatsApp or $42 per user, mostly in stock. Guess what? The market is valuing each FB user at more than $140. It seems like smart arbitrage if you ask me. Facebook didn’t pay for that acquisition. The market did. Facebook is using its currency (a.k.a. its shares) to secure solid positions in the mobile world.

WhatsApp is the fastest growing messaging app. Less than 5 years after its launch, it has 450 million users. In Zuckerberg’s words, “WhatsApp is the only app that has better engagement than Facebook.”

Facebook should not forget that those 450mm users are not really Whatsapp’s to sell. Companies don’t own their customers. They only rent them and they could keep them as long as they deliver positive experience.

They say that the best business ideas are those that are disguised like bad ideas. Maybe WhatsApp is a great idea in the eyes of FB’s management that looks like a bad idea to almost everyone else. If I have to choose, I’d give the benefit of the doubt to FB. They probably know what they are doing. The market seems to be doing exactly that as $FB is still trading near all-time highs.