If You Don't Get Position Sizing Right Nothing Else Will Matter

Money management, risk management, risk control, position sizing – whatever you want to call it — matters and matters tremendously. In fact, position sizing alone can make the difference between success and failure in the investing and trading business.

Position sizing is the answer to the question of how much. How many shares should I buy in relation to the size of my account and my risk tolerance? How many contracts or options? What is the correct size for my position?

How important is position sizing? It’s just about the most important thing there is in investing and trading.

In Trade Your Way To Financial Freedom, Van Tharp tested five position sizing models. For the purpose of this post the details of the five models are not important. However, the results are very important.

He used a million dollar hypothetical portfolio. The portfolio consisted of the 30 Dow Jones Industrial Average stocks. He tested five separate position trading models. All trades were made using the exact same buy and sell rules. The only difference in the five models was the size of the positions.

He made 595 trades over a 5.5 year period. The system produced 273 profitable trades and 322 losing trades for a success rate of 45.9%.

Here are the results:

The first model simply bought 100 shares of stock whenever a buy signal was given and sold the shares whenever there was a sell signal. It couldn’t have been more simple. The problem was the performance. The model only made $32,567 over five and a half years –a 0.58% annual return.

The second model used a fixed amount based on equity. It bought 100 shares of stock for every $100,000 of account equity. So, at the beginning balance of $1 million, the model would buy 1,000 shares whenever there was a signal. It made $237,457 for a 5.75% annual return.

The third model allocated 3% of equity to each position. So for a $1 million account the portfolio would buy $30,000 of stock each time a signal was given. It made $231,121 for an annual return of 3.86%

The fourth was a percent risk model. It risked no more than 1% for each position. In other words, whenever there was a 1% of equity loss it got out of the position.  So for a $1 million account it was risking no more than $10,000 per trade.

That model made $1,840,493 for a 20.92% annual return.

Hmm… now it’s getting interesting.

Finally, the fifth model was based on percent volatility. To measure volatility it used “average true range” (a common way to measure the volatility of a stock) over the previous ten days. It sized his positions at 0.5% volatility, or $5,000 per position based on a $1 million account. Therefore, it limited exposure to current market volatility or $5,000 per position. So if the average true range for a stock over the previous ten days had been $5 a share, the model would purchase 1,000 shares.

This model made $2,109,266 for an annual return of 22.93%.

Again, don’t concern yourself with the details of the above position sizing models.  It’s just important to understand the meaning of the results because that’s what can potentially change your financial life.

Think about it. All five models started with the same amount of money. All five bought the same stocks and used the same buy and sell signals. The only difference was the size of positions.

One model made $32,567 over a 5.5 year period. Another made $2,109,266.

That’s the difference position sizing makes.

I worked for Wall Street firms for over 20 years. I trained on Wall Street. I participated in hundreds of training courses, seminars, workshops. I read thousands of articles about investment strategy. But I seldom received training on risk management. And what I did receive was limited to simple asset allocation strategies.

I have to give Dr. Van Tharp credit for being the first to make me realize the importance of properly sizing positions. It has changed my whole perspective on investing and trading.