Ask Colin

Please explain standard position sizing or money management.

For me, money management means both position sizing and diversification rules. However, most traders do not bother much with diversification. This is probably OK if you are a short term trader. However, even then, I have some misgivings about neglecting it completely.

The standard ideas for diversification are that you do not put all your eggs in one basket. This is the standard way to deal with specific risk. So, portfolio theory will tell you that you diversify away most of specific risk with eight truly uncorrelated positions. The problem is that if you are only talking about stocks, then they are all to some extend correlated. You also cannot entirely divorce this question from market risk, because that is one of the sources of the correlation. I deal with market risk quite separately. So, you need more than eight positions, but how many more will depend on the degree of correlation.

The standard ideas for position size are that you only ever risk a small proportion of your total trading or investing capital on any one position. Note that the amount risked is different to the amount allocated, the latter being what we have dealt with through diversification. How the proportion of trading capital risked is set depends on many things, but primarily how it is calculated (is brokerage and slippage included or not) and the risk tolerance of the trader. It will also depend on the size of the capital available, since brokerage as a percentage of position size is important.

When deciding how much capital to commit to a stock, I use two tests - the position size rule (how much is risked) and the diversification rule (how much is allocated). Both must be passed, or the position reduced till it meets both. Even then, I will often reduce it further because my tactical plan calls for building a position in stages to keep risk lower.

My approach to diversification and position sizing is explained in detail in my book Bulding Wealth in the Stock Market.