The Ideal Position Size

While having dinner with a fund manager in Portland, Oregon a few years ago we got to discussing position sizes in a portfolio and what he said has stuck with me since then. When asked what his ideal position size was he said that he prefers to have no more than 4% of his overall portfolio in an individual position.  This implied that he preferred to hold about 25 positions in his portfolio.

Then he asked me what kind of position sizing I use and I told him that my standard position size was 5% of the portfolio but I was willing to build a concentrated position that amounted to 10 to 15% of the portfolio if I really liked a particular investment. I was thinking of Activision Blizzard (ATVI), a company that I thought had a great blend of good products, strong management, growing revenues, a strong balance sheet and decent valuation. I had about 15% of my portfolio in Activision Blizzard. He then told me that the reason he sticks to a 4% allocation is that often it is not our top idea that turns out to be a winner but something else in the portfolio that delivers the big gains.

Truer words were never spoken. Even as the market roared back from the depths of March 2009, Activision Blizzard along with the rest of the gaming sector has languished and has been range bound. In contrast micro-cap stocks in my portfolio like Gluu Mobile (GLUU) and Towerstream (TWER) that I had perceived as more risky went on to do very well.

A short exchange on Twitter last week between yours truly and a couple of value investors reminded me of the conversation I had in Portland. Value investor and blogger extraordinaire Geoff Gannon had a post on his blog Gannon on Investing that talked about how he likes to hold 5 micro-cap stocks. My interpretation of this statement was that he liked to hold 5 micro-cap stocks as part of a larger portfolio but as you can see from this tweet, he prefers a concentrated portfolio of micro-cap stocks.

I decided to check with a couple of professional investors to see what their preferred position size was. Michael Bigger of Bigger Capital told me that positions in his investment portfolio start out at 10% of the portfolio. A hedge fund analyst I exchange tweets with told me that his preferred position size was 5%

So what exactly is the ideal number of stocks for a portfolio? Is it 5 stocks, 25 stocks or even more? For every early Warren Buffet who liked a concentrated portfolio of stocks, there is a Peter Lynch who used to hold dozens if not hundreds of stocks in his Fidelity Magellan fund that delivered outsized returns to its investors from 1977 until Mr. Lynch retired in 1990.

There are a number of factors to consider including the size of the portfolio, the type of investor you are (value, momentum, growth at a reasonable price) and your level of risk tolerance before you can figure out the ideal position size that works for you.

Risk tolerance is an important part of position sizing and by increasing the number of stocks in a portfolio, you can reduce some of the non-systemic risk that is specific to each stock. Various studies have shown that the benefits of diversification drop off after you add about 20 stocks to a portfolio and after 30 stocks additional gains are negligible.

The answer really comes down to whatever helps you sleep peacefully at night. While for some people that would mean a diversified portfolio of stocks across different sectors, market-caps and countries, there are others like Geoff who find it difficult to sleep at night because there are too many eggs to watch.

For additional reading, check out this presentation titled How Concentrated Should You Be? (PDF) by Zeke Ashton of Centaur Capital Partners.

Related Posts:

Ten Reasons I am Buying Activision Blizzard (ATVI)

Towerstream (TWER) Trading Below Cash

The Apple App Store Ecosystem and Glu Mobile – Part 2

One Comment

  1. chrispycrunch
    January 21, 2011 at 9:00 am

    The idea number of companies to hold to be truly diversified is 14. As for concentration, you buy more as a company fundamental is better than you though (although it gets pricier )

Leave A Comment

You must be logged in to post a comment.