TRADING IS NOT
about taking risk, but avoiding it. To that end, I am always reluctant to commit too much capital to a single position. Not because I don't believe in my flair for stock picking, but because sometimes the best way to manage risk is not to take it in the first place.
Forget Jack Welch and Michael Dell. When you buy a stock, it isn't the company's management you should be focused on, but that of your own portfolio. And while security selection gets all the headlines, it's money management namely position size that ultimately has the biggest impact on your bottom line.
You want to buy the dips? Or stocks making new 52-week lows? Go ahead, knock yourself out. But please do yourself a favor and keep the stakes small. Most people won't hesitate to drop 15% or more of their portfolio into a single name at a single price. That isn't just dangerous, it's insane. A good portfolio should be structured like a good life. Everything in moderation.
Say it with me now: Size kills. Position size is what did in Nick Leeson, the kid whose huge bets took down Barings, England's oldest merchant bank. It's also what trashed Long-Term Capital Management, whose wagers almost took down the global financial system. No matter what sort of analysis you use, nothing will wreck a portfolio faster than putting too much of your assets in one particular holding. Despite the misconception that traders love to take big rolls of the dice, the truth is that large positions grow large, they don't start out that way. So while there is nothing wrong with having a position appreciate to become 15% of your portfolio, putting that much in at once is suicidal.
That's why I am always looking for ways to diversify my portfolio. I diversify by asset class by trading not just in stocks, but also in bonds, commodities and other noncorrelated investments. I diversify by time by having both short- and long-term time horizons for particular plays. I diversify by sector, stock and, in this case, price. Put 15% or more of your portfolio into one stock at one price, and you are throwing a lot of chips on a weak hand. In this dangerous scenario, often even the normal volatility of the security will be enough to throw traders out of otherwise smart positions.
No matter how good your research is, not every stock you pick will be a winner. I have losing trades all the time. In fact, it's OK to have losing trades the trick is not to have them be the biggest positions in your portfolio. Your biggest open trade should be a winning stock, not a losing one.
Want to see the risks of heavying up on a single bet? Just glance through some of the biggest losing funds over the last 12 months. What has killed Boyle Marathon fund, the largest percentage-losing fund among large-cap blended funds, isn't the 53% year-to-date plunge of Applied Micro Circuits alone, but that stock is the fund's biggest position, at 8.66% of the portfolio. The largest holding at Millennium Growth fund is JDS Uniphase (-21% year-to-date), which constitutes over 17% of the fund's assets. Ameritor Industry fund, the largest percentage-losing fund among the large-cap value portfolios, has its largest position in Cisco Systems (-31% year-to-date), which makes up 24% of the fund's portfolio.
Sit on losers and you'll suffer an opportunity cost. But sit on (or add to) big losers, and you'll just plain suffer. It's this lack of trade management that has seemed to havehindered Don Yacktman
and so many other "focused" funds. They were focused, all right on losing positions.
Large positions are even more lethal when, as is often the case, they're accompanied by an inordinate amount of leverage. When you're overweight in a cash account, I'll reluctantly accept the argument that, worst case, you're sitting on a limited loss...a paper one at that. But when you've financed those large positions by buying stock on margin or by cranking up your position size in futures, you've got to be right or get out. It was thanks to leverage that Leeson managed to lose $1.4 billion.
Our job as traders isn't to know the future, but to survive it. The best way to avoid getting hurt is to avoid putting yourself in a position to be hurt. I keep my positions small and my risk manageable. My high-school hockey coach was right: A good defense is your best offense.
So how big should you trade? And how should you manage a trade once you've put some money on the line? I'll discuss these topics in a later column.
Capitalistpig.com, a Chicago-based hedge fund. At the time of writing, Hoenig's fund was short shares of Cisco Systems.>