Art of Trading: Risk Management — Portfolio Position Sizing 2/3

Understanding Risk for More Profitable Trades

Please Note: This is the second portion in a series entitled The Art of Trading: Risk Management. For a more thorough understanding, I recommend reading the first section of this topic entitled Trading Mindset.

Portfolio Position Sizing

How do you size your portoflio positions to reduce risk while maximizing profit?

The most common mistake made by a new investor is what I refer to as the “riches to rags” strategy. From every step of my career, I have been approached by investors who insists that their road to success lies in throwing all their portfolio into a single investment and hoping for the best. Then they rage as their investment fails to deliver and their entire portfolio suffers.

Greed is a powerful motivator for people and emotion clouds their judgement. They assume that if this ONE investment takes off they will be rich forever and they desperately throw cash at the opportunity to make their dreams come true.

THIS IS WRONG. YOU WILL LOSE EVERYTHING. Very quickly, too.

The key to good risk management in your portfolio is positon sizing. When you are trading, you need to understand an asset’s purpose in your portfolio because your investment size will vary accordingly.

Assets have one of four purposes in a portfolio including

Shorter-term Capital Appreciation — 5–10%

These assets have explosive growth but also have high failure rates. Their long-term potential is considered limited due to their volatility and they should only take 1–5% of your total portfolio. Examples include: short leveraged scalps, ICOs, and some small cap coins.

Longer-term Capital Appreciation — 10–20%

These assets are longer terms holds and their value is from capital appreciation however, they are too volatile to be a store of value. Examples include: futures swing trades, mid-cap alt coins and some small cap coins.

Store of Value— 40–50%

The positions provide stability to your portfolio and help maintain an overall healthy sized portfolio. These assets can appreciate in value, have some volatility but overall remain fairly stable in their slow but steady growth. Examples include: large-cap coins like Bitcoin, Ethereum, and Litecoin. (Cash is also considered a store of value, but this is an investment portfolio and cash plays a very small role in it. You should always have cash on hand outside of an investment portfolio.)

Passive Income — 15–25%

These assets may cross over with store of value coins however, their value comes from mainly from their ability to provide a passive source of income. This income can build on the size of an existing position, create a new position or pay expenses. Examples include: Proof-of-stake coins (NEO) and some master-nodes (Smartcash).

What does this have to do with position sizing?

You will notice each asset purpose had a percentage across from the bullet point. This is my personal preferred position sizing for these investments, but it will vary slightly from person to person. You’ll also notice that the most stable investment had the highest percentage of allocation. People make the mistake of investing an in-ordinate portion of their portfolio into the first category of investment “short term capital appreciation”, volatile assets that make massive swings in movement.

For the purposes of trading, portfolio sizing most commonly applies to the smaller two categories of purposes; shorter- and longer-term capital appreciation.

Let’s consider the trading of alternative coins (altcoins) that fall into the first two categories. Altcoins made impressive gains at the end of 2017. The gains were no longer being counted in percentages but in “_x” values, the number of factors they have multiplied over their initial investment. However, people see the sea of green on exchanges and make the mistake of assuming every coin choice is a winner. This is a mistake. At any moment a coin suffers from a black swan event, loss of liquidity, and the price can plummet in seconds.

If you invest a large portion of your portfolio into a small-cap altcoin, you may reap the benefit of a single good trade, however, if suddenly the market turns against you, two factors come into play. First, since you have used an inordinate amount of your portfolio, your loss will be magnified. Your portfolio will have been decimated by a single volatile asset and the second factor comes into play: your emotion. As your whole trade (or the majority of your portfolio) plummets into the ground, emotion overruns careful trading plans. While many people claim it won’t happen to them, the “deer in the headlights” moment is real, and you will panic as your lifesavings turn to dust. Some angrily blame “outside forces”, some frantically pray that their investment comes back and some demand that others cover for their loss. Finally, some will vow to never trade again and walk away from an easily managed failure.

Unfortunately, if these people merely kept this volatile asset as only a small portion of their overall portfolio, they would benefit from a slightly better perspective. If 1% of your portfolio suddenly tanks, you are better able to reflect on it as a small loss. You are diversified well enough that that loss doesn’t hurt you, your trading plan will kick in with no emotion and you can re-evaluate the purpose of the investment. If you invest 1–2% percent into multiple different small volatile projects, you can more easily manage the risk that comes with wild swings of alternative investments.

One last consideration before moving on, many investors claim that “your 1% is my 20%, so I should invest 20%!”. This is foolish logic, because in the long run you have more to lose if the asset drops. Most of the time, the reason 1% is suggested is because the trade is risky. Again, consider that if you lose 1%, the worst that can happen is a tiny ding to your portfolio, However, if you invest 20% and get greedy, you run the risk of a high loss.

Moreover, this is simple compounding interest. Let’s say you make a couple of good altcoin trades, if your 1% investment increases by a factor of 5, that 1% becomes 5%. If you were this successful on a regular basis with a couple small trades, you could double your portfolio little as 15–20 trades. This minimizes your risk by keeping your entries small, but also allows you the diversification in case one coin goes the wrong way.

Just remember, the more volatile the investment, the smaller the investment amount.

-> Continuation ->

Please Note: This is the second portion in a series entitled The Art of Trading: Risk Management. To finish the series, I would recommend reading the third section of this topic Stop Losses and Final Thoughts.

If this has been of assistance to you, please consider a tip. Thank you for your consideration.

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Disclosure

The opinions and investment strategies of the author are their own and not to be construed as investment advice. With any type of investment, the potential exists to lose some or all of your investment. The author makes no guarantees of gain or increased profit and cannot be held responsible for losses incurred.

Cross Posted on Medium.com
Credit to Pexels.com for photos.