Thinking about position sizing? This can help

Have you ever wondered how much you should invest in each stock in your portfolio ? also called position sizing?

You can of course just say I want to diversify my portfolio over 15 to 30 companies, divide the amount you want to invest by that number and invest the same amount in each company.

But this approach has a problem?

You are not allocating money you are allocating risk

If you think about it carefully, with position sizing you are not allocating money, you are allocating risk between the different stocks in your portfolio.

Ask yourself – should you invest the same amount in a volatile (big up and down movements) stock as in a company with a more stable share price? Think of an investment in Nestle compared to very undervalued small cap company with problems.

The same investment gives you more risk

If you invest the same amount in each company you increase the risk in your portfolio towards the most volatile companies.

For example, some stocks in your portfolio may move up and down by 0.3% per day while other companies may move up and down by over 3%. This means the profits of your portfolio will mainly be dependent on the more volatile companies because they have bigger movements.

To give the more stable companies the chance to give you the same amount of profit you should invest a bigger amount in them, and less in the volatile companies.

It is called risk parity – we call it Target Weight

This idea is called risk parity ? it means the position size of each investment is based on the volatility of the company’s stock price.

In the Quant Investing screener we called it Target Weight and it is simply the volatility adjusted recommended position size (in %) for a stock in your portfolio. This is what it looks like:

Suggested portfolio weight (Target Weight) based on the stock’s volatility

How is it calculated?

Don?t worry about the calculations below – I included it here to show you exactly how risk parity works and how it is calculated.

In the screener this is all done for you, keep reading and I will show you:

where you can find it and
how to use it in your portfolio.

This is the formula:

This is how risk parity is calculated.

Number of shares to buy = (Total capital you have to invest * Risk Factor) / ATR

Total capital you have to invest is simply the total size of the amount you want to invest.

Risk Factor

Risk factor is simply an arbitrary number that you select to where you determine the daily impact of a stock in your portfolio.

For example, if you choose 0.003, then you are setting the daily movement impact of this stock on your portfolio of 0.3%.

This of course assumes that the ATR (explained below) stays on more or less the same as in the recent past.

The lower you set the Risk Factor, the smaller your investment in the stock will be.

Target Weight uses 0.1%

In the screener to calculate the target weight we use a risk factor of 0.001 or 0.1%

Average True Range – ATR

Average True Range (ATR) is the average volatility of the company’s stock price measure as the maximum of the days move (high or low) from the previous day.

ATR is shown in the value of the stock’s price movements, for example $1.3 or ?0.4.
In the screener we use the past 100 trading days (five months) to calculate the average True Range (ATR).

Target Weight example

Here is an example so you can see how Target Weight is calculated in the screener:

Total capital you have to invest: ?100,000

Risk Factor: 0.001 (equals 0.1%)

ATR of the stock: ?1.10

Current share price: ?43.50

The number of shares you should buy is: (100,000 x 0.001)/1.10 = 91 shares

Value of the transaction = 91 shares x ?43.50 = ?3,959 or 3.96% (3,959/100,000) of your portfolio

Maximum position of 7%

In the screener the position size or Target Weight varies from 0% to 7%.

We have limited the maximum position size to 7% or 15 positions.

We chose this number because 15 companies give you most of the benefits of diversification. This of course only applies to the companies with the lowest volatility. Please remember that the Target Weight is only a suggestion, you are of course free to use whatever weighting you feel comfortable in your portfolio.

It changes all the time

But the volatility of a stock changes all the time, you may be thinking. That is correct and that is why the Target Weight changes on a daily basis.

This however does not mean that you must change your position size all the time – that will cost too much in trading fees.

To keep trading costs down we suggest that you check your position size on a monthly basis and only trade if the Target weight has changed by more than a certain percent that you can set yourself, a change of 2% or more, for example.

This means if the Target Weight was 5% when you invested you will only adjust your investment in the stock if the Target Weight changes by more than 2%, to 3% for example. If this happens you sell some of the stock until the company makes up only 3% of your portfolio.

If a stock price has a large movement in a day, for example more than 10% you may want to adjust your investment immediately as this move signals that something important has happened which makes an adjustment necessary.

Where can you find it?

In the screener the Target weight is available for all of the more than 22,000 companies. To see the Target Weight simply select it as an output column of your screen.

How to select Target Weight as an output column

How to keep track of the Target weight for your whole portfolio?

As mentioned the Target Weight changes on a daily basis. To keep track of it (and all the other ratios for your portfolio) simply save watchlist of all the companies you want to track. This is how you do it.

Create your watch lists

Watch lists are very easy to create.

Once you have logged into the screener click the My Watchlists button. Then click Create a Watchlist.

How to create a watchlist

Type in the name of the watch list you want to create and click the Save button.

How to save a watchlist

Add companies to your watch list

To add companies you first have to load your watch list. To do this click the My watchlists button then click Load a watchlist.

First you load your watchlist

Load a watch list by clicking the drop down list below the heading Select a watchlist, and then click on the watch list you want to add companies to.

How to select a watchlist

Once the watch list is loaded you can add companies by typing the name of the company in the block below the heading Add securities to the watch list.

As you type a list of company names will appear. To add the company simply click on the company name.