10/13/13

Average investors make a lot of mistakes. Among those mistakes, they spend so much time worrying about complex stock picking issues and unrealistic “win rates.” They ignore the very simple things that are fundamental to investing. Perhaps the biggest mistake investors make is ignoring the concept of diversification.

Now, I’m not talking about adding gold or Chinese stocks to your portfolio. A basic, yet powerful diversification tool is position sizing. Most people blindly buy a fixed amount of shares of a stock, regardless of the price of the stock, regardless of the volatility of the stock.

An easy way to position size is to give each holding an equal chance to perform for you. This means for
each position you buy, you allocate the same amount of money.

Let’s look at a simple example: Assume I have a $100,000 account with a portfolio of 20 stocks … if TEN of my stocks over the next year do nothing (trade sideways), SIX stocks go up an average of 30%, TWO stocks go up an average of 150%, ONE stock drops 50% and another stock goes to zero (a 100% loss).
Would you consider that a success or failure?

My guess is most average investors would consider it a failure. They held ten stocks that didn’t go up. One went to zero.

My take: If you could replicate the performance of that portfolio, year-in and year-out, over your entire you life you would be the best investor in the history of the world. And your wealth accumulation (just on compounding that initially $100k over a lifetime) would land you in the top 1/10th of 1% of the wealthiest people in the world.

So, let’s do the math on the above portfolio scenario.

On a $100,000 account 20 stocks equal weighted would mean that you would invest $5000 on each stock. So TEN stocks that went up zero would still be worth $50,000. The SIX stocks that went up on average of 30% would now be worth $39,000 (on $30,000 originally invested). The TWO stocks that went up 150% on average would now be worth $25,000 (on $10,000 originally invested). The one stock that dropped in half would be worth $2500 (on $5,000 originally invested), and the one stock that went down 100% would be worth zero ($5,000 loss).

Okay, so let’s add these values: $50,000 + $39,000 + $25,000 + $2500 +0 = $116,500

Our $100,000 portfolio is now we worth $116,500. That is a 16.5% annual return. That’s double the average historical return of the S&P 500. And a 16.5% annualized return, compounded on a $100,000 initial investment, goes to $177 million in 50 years.

So now you see the value of diversifying. And the easy way to get diversification is through position sizing.

Put simply: It increases your odds of making money. And making money is THE PRIMARY GOAL in investing.