Why Size Matters Through the years, one aspect of trading has created more uncertainty, generated more volatility, injected more emotion, and had a greater negative impact on the returns of otherwise excellent managers than any other. Whether I work with a 25 year veteran of the industry or a brand new portfolio manager, this is by far the one facet that perplexes almost every single one of them. It’s the one that no one talks about and everyone is afraid to ask about for fear of looking like an amateur. However, whether I mention it in a talk, broach the subject in an investment committee meeting or raise the topic in a coaching session, it immediately triggers the undivided attention of everyone who manages a portfolio. If you are one of them, you already know what it is. As if that wasn't enough, I will also argue that it lies at the heart of the reason why most trend followers have done so poorly over the past several years, a period which arguably should have been one of the best for investors of that breed. The issue is how to size positions and it is the topic for this edition of Seeds of Thought.
Many traders readily admit that they make something close to 80% of their profit from just 20% of their trades. Rather than arguing here why that should not be the case, I will focus on what it does to the sizing process and the damage it causes. When you believe that only a couple of trades hold the key to your success in a given year, you tend to approach position sizing with the idea that each trade has to be on in a size that has the potential to “move the needle”, in case this one turns out to be one of those few. You think about where the underlying position can go to and how much you need to have on for it to have a meaningful impact on the portfolio if it does. Of course, you recognize the possibility that it may not work out as planned and so you set a stop loss level for the underlying position based on how much you are prepared to lose.
One thing cognitive science has clearly taught us about ourselves, is that we are natural born optimists, and this methodology for sizing is proof. When entering the trade, it embodies all that is possible. We see far more clearly how it can go right than wrong. Why else would we enter it? If it goes in the right direction straight out of the gates and continues without much pain along the way, that optimism grows, making it difficult to imagine how it could possibly go wrong. You feel confident in your abilities and see the price action as confirmation of your initial beliefs. With this newfound confidence, you increase the size, moving up your stop-loss along the way. After all, that would be the prudent thing to do. (Or is it?)
Unfortunately, as was acknowledged at the outset, most of the trades don’t wind up being big contributors to the portfolio’s profitability, which is why we tend to use “tight stops” as a key risk management technique. After all, if a trade isn’t going to be moving the needle in a positive way, we need to ensure that it doesn’t put us in a hole form which we can't recover. As soon as a trade exhibits any sort of uncertainty, our overly optimistic expectations at initiation are called into question. With every tick in either direction, the trajectory of that trade is extrapolated out into the future as either a positive game changer or ruinous disaster. Swings of such magnitude can be mentally and emotionally exhausting, making us more and more nervous, less optimistic and increasingly risk averse.
Essentially, the fundamental problem with this sizing methodology is that at initiation, that moment when we determine the proper size, we are focused almost exclusively on the upside potential, and from the first moment that we realize it won’t be the unobstructed slam dunk we’d foreseen, our expectations are adjusted, and so naturally we become more focused on limiting the downside. That can be an issue in and of itself, but the impact of it has been exacerbated over the past 7 years. The reason is that risk controls for portfolio managers and even many asset allocators have been tightened. Portfolio stops have gotten smaller and questions from the board come sooner than they used to. At the same time, our performance expectations have been slow to adjust in accordance. In other words, we expect to generate the same returns with tighter stops and risk constraints. So, we get into positions (and add to those that work initially) by sizing according to our performance expectations, and get taken out (often prematurely) according to the reduced risk limitations. Simply stated, we are oversizing positions by approaching it from this side.
Instead, position sizing should be approached from the opposite end of the spectrum. Sizing should be the very last step in the investment process. It comes after the view is developed, the asset and instrument is selected and the structure is determined. Only after expectations are set for where the underlying should go if I’m right and where it just simply should not trade unless I’m dead wrong, should size even be considered. The stop-loss level should be determined by market factors, not as it relates to your p&l. Period. The next step is to allocate an amount of capital you are prepared to lose should things not work out as expected. In other words, what is the most you are willing to lose if you are absolutely dead wrong?
With both the appropriate, market driven stop-loss level and the maximum notional loss you are willing to accept having been identified, determining the maximum position size requires a very basic calculation. Simply divide the notional amount you are prepared to lose in the trade by the percentage distance from entry level to stop-loss, including expected slippage, and you have the maximum notional size for the trade. If, when you multiply that number by the percentage you expect to make if all goes as expected on the upside, is not enough to “move the needle”, you have a decision to make. You can either acknowledge that the risk/reward profile of the trade wasn’t quite as good as you thought and pass on it, or accept that while this particular trade may not be the one that makes your year, it will be managed in a way that dramatically improves the odds of it being a positive contributor in the end. When you do that, you will reduce your dependence on hitting the lottery a couple of times a year in exchange for more sustainable, consistent, and most importantly, profitable results. About the Author For nearly three decades, Stephen Duneier has applied cognitive science to investment and business management. The result has been 20.3% average annualized returns with near zero correlation to any major index, the development of a billion dollar hedge fund, the turnaround of numerous institutional trading businesses and career best returns for experienced portfolio managers who have adopted his methodologies.
Mr. Duneier teaches Decision Analysis in the College of Engineering at the University of California Santa Barbara.
Through Bija Advisors' publications and consulting practice, he helps portfolio managers and business leaders improve performance by applying proven decision-making skills to their own processes.
As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America and Managing Director of Emerging Markets at AIG International. His artwork has been featured in international publications and on television programs around the world, and is represented by the world renowned gallery, Sullivan Goss. He received his master's degree in finance and economics from New York University's Stern School of Business.
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