Why starting with small portfolio positions will improve your long-term success
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Read time: 4 minutes
There are generally three levers you can pull to influence your investing results:
- Position sizing
- Risk-reward ratio of the investment
- Your hit rate, i.e. how often you are right in your decisions
I will explain them all in detail in due time - dedicating today to the topic of position sizing.
When you are just starting out in investing, it can be difficult to decide on how much of your total capital should be allocated to each investment.
This is what position sizing is all about.
Defining the right size of a capital allocation is key for your long-term "survival" as an investor. You don't want one investment to jeopardize your whole investing future.
Meaning that you don't want to lose such a big part of your capital that it will take a long time just to recuperate the lost funds.
Assuming you have reasonable returns.
Not suffering fatal losses, is even more important when you consider that even the best investors only are right in their investing decisions 6 out of 10 times.
Keep the stakes small in the beginning and increase them as you get more experienced
It took me a very long time to realize this.
Following the advice of some of the greatest investors - like Warren Buffett or Monish Pabrai - I always thought that value investors should not trade often, don't need to make many investments, and should run a concentrated portfolio to maximize returns.
Generally speaking, this is good advice, for several reasons:
- The more often you trade, the higher the cost of commission, which can diminish your investment return.
- To enjoy a life-time of successful investing, you really don't need many successful investments - a handful of great stock picks are more than enough to make you wealthy.
- As value investors, we do thorough analysis and in turn develop a deep understanding of the companies we invest in. Therefore, we can confidently concentrate our capital in just a few investments. Understanding a company is part of our risk management.
- And when you really found an undervalued company, you want your extensive research to pay out. So value investors typically put meaningful amounts of capital in each one idea.
But...
...when you just start out, you might lack the experience to decide if this or that investment is a good bet.
You might not have lived through a market downturn while being invested.
You might not know yourself well enough or how you will behave when fear creeps in.
You need to expose yourself to learning opportunities
Learning from real world examples (and own experiences) is the key to rapid learning.
The learning effects of reading about investing, listening to podcast, watching videos or even teaching others pale in comparison to engaging in it yourself.
This includes doing your own research, learning about the company's finances and competitive advantage.
But also the emotional experiences and internal dialogues that come when your own money on the line (or the money of your clients).
The solution?
Even when you have found an objectively undervalued company, refrain from putting a big chunk of your capital to that one idea.
Try to experiment with many small bets. Because if one fails, you won't suffer a huge capital loss.
This way you increase your investing runway.
That is the time frame you will be able to participate in the market because you have the funds to invest.
You want to increase your chances of learning by having time; and many small investments (or experiments for that sake) running in parallel.
Because:
Remember: There is always another bus coming. Don't worry that you will miss out on any one investing opportunity.
Don't fall prey to the FOMO.
Collecting those learning experiences will therefore help you with:
- Proving your investment theses
- Learning how to manage your own emotions
- Not becoming paralysed from taking action just because your one big bet isn't moving in the right direction
I learn the last point the hard way.
One of my investments is a considerable position in Qurate Retail. They do old-school TV shopping and catalogue sales.
The company undergoes a turnaround after multiple unfavourable developments in the past few years.
However, they boast a 99% retention rate of their best customers. So, one could say these customers are hooked on the services and products Qurate provides.
This customer group comprises only 17% of the total customer base - but rakes in 80% of their revenues.
The company already looked cheap in 2021.
But it lost 90% of its market cap in the following two years.
Would I have started with a small position and subsequently build it bigger as the share price fell - or waited until now when there are first signs of recovery - it would have saved me many head aches.
But I probably wouldn't have written this newsletter, neither.
So, at least, you can benefit from the learnings of my mistakes.
There is nothing wrong with a concentrated portfolio of just a handful of investments.
But increase your stakes as you get more experienced.
It will save you lots of pain.
Happy investing.