What Is Your Edge?

Position Sizing & Time Horizon: Two Advantages That Individual Investors Have Over Institutions

Over the last couple weeks I have been thinking about what the next couple years will look like for my portfolio. While I’m very optimistic, one of the things that I keep coming back to is a question:

What Is Your Edge?

Is it knowledge of a certain sector? Understanding market dynamics? Or is it behavioral? For me, two of the most obvious advantages individual investors have are position sizing and time horizon. I think many investors struggle with both topics to varying degrees. Should I put 5% of my portfolio in a single stock? 10%? 20%? 50%? Where is the line where it gets to be too much? This is a question each investor has to answer for himself. There’s no one size fits all approach to this question.

Time horizon is another behavioral edge that is available to individual investors. The idea of making a quick buck trading in and out seems appealing at first, but I decided that approach isn’t for me (after a couple painful lessons). If it works for you, great, but I think that many investors would be better off with a 3 to 5 year time horizon and had longer average holding periods. Again, there is no one size fits all approach. Some people can hold for decades, others feel the need to trade frequently. Today I’m going to talk about my thoughts on position sizing and time horizon while discussing some of the stocks in my portfolio.

David vs. Goliath

Institutions have plenty of advantages in today’s financial markets. Whether it’s transaction speeds for high frequency trading, massive research budgets, or access to Nancy Pelosi’s latest stock pick, Wall Street has plenty of ways to tilt the odds in their favor. However, I think individual investors can use position sizing and a longer time horizon to even the odds a bit. A lot of institutions have rules around position sizing that limit how much can be invested in one opportunity. In many cases, they can’t have portfolio weights over 2%, 5%, 10%, or whatever the line is. For individual investors, it’s up to your risk tolerance, but a concentrated portfolio is what appeals to my investing style. It’s a double edged sword for sure. If you have conviction on large positions and you’re right, it’s very profitable. If you have large positions and you’re wrong, it’s very painful.

Having a longer time horizon is the other thing that can give active individual investors an advantage. I use the term active loosely here. I keep an eye on my portfolio, what’s going on with each sector and company I’m invested in, but I don’t like trading too frequently. I prefer to go months without trading because that means the voice in the back of my head saying “buy this, sell that” is quiet, and I’m giving the bullish thesis on stocks in my portfolio time to play out. The average holding period for a stock is less than a year now (potentially as little as 5.5 months), and for a lot of institutions, I’m sure half of a year seems like an eternity.

Plenty of institutions have monthly or even weekly performance targets, which means they have to focus on all of the short-term noise (which there is a lot of these days). They hang onto every word of Federal Reserve meetings, debate potential interest rate hikes or drops, weekly commodity price moves, and whatever else might impact what is in their portfolio. I prefer to zoom out and look at the big picture over a three to five year timeframe. If I think oil is going higher over the next couple years, that might have an impact on trades I’m making. I’m not going to get caught up in oil bouncing all over the place week to week, or other short-term market moves once I have made a decision to buy something.

I’ll reevaluate my assumptions along the way, but I think it’s easier to go from a long-term view of what has an impact on companies and the actual business, instead of what fluctuations in the market might or might not happen on a daily or weekly basis. For me, there is a difference between being an investor and being a trader. I would rather look at the fundamentals of a business, and buy a stock to hold onto it for years, instead of trying to generate returns by trading in and out of something. If you can figure out what works for you as far as time horizon and position sizing, you can lean into the advantages that small investors have against larger financial institutions.

Position Sizing

Financial writers have spilled a lot of ink writing about diversification being important, or being a “free lunch”, or whatever other cliché you can think of. Speaking of clichés, now is a decent time for a Warren Buffett quote:

“Diversification is protection against ignorance. It makes little sense if you know what you are doing.”

I like to think I know what I’m doing, and my portfolio is concentrated in what I think are the most attractive opportunities. I have talked about each of the things I’m invested in, but I would rather put 10%, 15%, or 20% of my portfolio in my best idea instead of 3% in my 15th or 20th idea. I won’t go into details here, but readers can see actual weights in my recent trade update post. What I will say is that my top 5 positions make up the majority of my portfolio. Every investor has their own risk tolerance, but I find the risk/reward most appealing in taking large positions in asymmetric opportunities.