Determining How Much to Allocate to Each Investment

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The influence any single investment has on your overall portfolio’s performance depends significantly on its position size. Position size is the percentage of portfolio dollars allocated to a specific investment, such as a stock. To use a simple example, say an investor has a $100,000 portfolio invested in 20 stocks. Under an equal-weight scenario, each stock would have a position size of 5% of the overall portfolio’s value. In other words, $5,000 would be invested in each of the 20 stocks.

Focus on Dollars, Not Shares

Notice how the number of shares is not discussed. When allocating, focus solely on the amount of dollars and not the number of shares. If you focus on shares, you could end up buying 100 shares of a stock trading at $20 and 100 shares of a stock trading at $50. The dollars at risk are $2,000 and $5,000, respectively—a big difference. If you allocate $5,000 to each stock rather than being concerned with how many shares you are buying, the amount of money at risk is the same for the two stocks.

Going back to the original example of a 20-stock portfolio, if the price of any one of the stocks were to drop to $0, the maximum downside risk posed to the portfolio by that particular stock would be 5%. Since your dollars are distributed evenly, each stock’s downside risk is also evenly distributed.

What if you held a smaller number of investments? The percentages would change accordingly. In a portfolio equally distributed between five stocks and five funds, each investment would pose a maximum downside risk of 10%. The lower the number of investments you hold, the larger the risk each investment poses to your portfolio. Conversely, holding more securities (stocks, bonds, etc.) and funds decreases the risk each investment poses. This is why diversification depends in part on holding an adequate number of securities.

Periodically Take Action to Maintain Balance

Equal weighting only lasts temporarily since stocks and bonds, and funds that hold them, do not move in lockstep. Within asset classes, some securities rise, some stay flat and some fall. Even if all of the individual investments in your portfolio do move in the same direction, the magnitude of the price changes will differ. This causes the position sizes to be ever-shifting.

Small divergences are not significant. If one investment accounts for 6% of the portfolio’s overall value instead of 5%, the proportionately higher risk posed by that one investment is not significant. The transaction costs of constantly bringing the portfolio back to an equal weighting can negate the benefit of making small changes. This is why even equal-weighted funds tend to limit how often they adjust the position sizes of each investment.

Bigger divergences, however, deserve attention. If one asset class (e.g., stocks) realizes higher returns than another asset class (e.g., bonds), the risk profile of the portfolio is altered. During a bull market for stocks, the portfolio could become too tilted toward stocks and incur more price volatility than you are comfortable with. In such situations, it makes sense to rebalance across asset classes, which, in this example, entails shifting dollars out of your stocks and your stock funds and buying bonds and bond funds.

Within an asset class, if one or two investments perform exceptionally well, their position size could become exceptionally large. This could not only lead to greater investment-specific risk (the potential damage to your portfolio caused by a significant drop in one security or fund), but also alter your portfolio’s overall allocation. In such scenarios, first check to see if the investment’s valuation is too high. If so, consider selling it outright. If not, consider reducing the position size down closer to the average dollar amount of your other holdings to reduce the investment-specific risk.

Establish Reasonable Bands of Divergence

The key is to establish bands of divergence wide enough to let your winning investments run, but not so wide that position sizes become too large. A useful rule of thumb is to adjust your asset class allocations when they move five or 10 percentage points off target. For individual investments, consider paring or selling them when their position size grows beyond 2.5 times the average size of your other investments.

—Charles Rotblut, CFA, Editor, AAII Journal

Discussion

Manuel Zenick from MD posted over 12 years ago:

Regarding the question of rebalancing, with interest rates very low and likely to rise slowly given the recent action by the FED it would appear that bond prices will fall. Therefore I am skeptical about whether to be in bonds at all right now. Would it make more sense to rebalance into conservative stocks with low volatility and avoid bonds?

Bob Voyt from MI posted over 12 years ago:

I have been 95%+ invested in equities for the past five years with excellent success. Feel the potential for return on average far exceeds that for bonds.

O. Timothy Moore from OR posted over 12 years ago:

It would seem that using a combination of Chuck Lebeau's Average True Range (3 times ATR) to set a stop loss, and Van Tharp's money management of risking no more than 2% of capital (and preferably only 1%) would address the issue of how many shares of a given stock to purchase. Coupled with Kirkpatrick's or Carr's Relative Strength models to pick the stocks to invest in, and one has a program which reduces the risk factor above significantly and answers both how much to invest in a stock and how many shares to purchase. And then with the difficult question of when to sell - the one time where the investor has the least control, use Lebeau's Chandelier Exit.

Edna Derrick from VA posted over 12 years ago:

I am reluctent to commit any new money into bonds as interest rates are almost certainly to go up. Also, the rates are so very low. That bring up the difficult question of rebalancing at this time of the year. ED

Tony De Marco from DE posted over 12 years ago:

I read of an interesting way to rebalance. Just put your dividends into a cash account and when enough is accumulated, you buy some of whatever you need to rebalance. No tax consequences either.

Jerry Mead from IL posted over 12 years ago:

I agree with Tony. Dividends producing mutual funds automatically transferred to a fixed income fund paying a rate at least equal to inflation (3%) works to keep allocations somewhat balanced. I also use the trailing performance YTD of the top 10 mutual funds (returning over 10%) in the portfolio to allocate new funds from the accumulate dividends of the fixed income fund. Keep an eye on current YTD performance to make changes as needed to allocations based on large movements in fund performance.

Joseph Addonizio from CA posted over 12 years ago:

This article is sophomoric piffle coming from a CFA,meant for AAII members.I see that this is for beginning investors,but are they in fifth grade?Thanks,fellow members,for providing the most insightful input to this site.

J. Clifford from DC posted over 12 years ago:

Does this strategy applies if you have a mixture of income stocks and purely speculative stock? For example, using your 100K and 20 stocks, you have $90 thousand in 10 income producing stock and just $10 thousand in 10 speculative stocks. I may never want to rebalance the speculative stocks, particularly not with the conservative income stock.

Bernard Dowd from IL posted over 12 years ago:

Good basic info. For the more "sophisticated" investor, allot a % of your portfolio for "gambling" or "playing" the market and can tolerate loss.

Walter Knapp from NJ posted over 12 years ago:

What's wrong with a trailing stop loss order for the re-adjustment amount of your winners. Thus letting your winners run and still having some downside protection.

Charles Rotblut from IL posted over 12 years ago:

Manuel/Bob - Avoiding bonds only works if you have the temperament to stick with stocks in a falling market environment. Bonds can offer a counter-balance for stocks during corrections and bear markets. If worried about interest rates, you can consider bonds or bond funds with durations of five years or less. O. Timothy - If following the systems work for you, great. But, at only 1% or 2% of allocated dollars, the impact of any winning stock won't be significant. Plus, trading and transaction costs will be higher. Tony/Jerry - Allocating dividend, and interest distributions, to cash is certainly a method for rebalancing. Since this article is oriented to novice investors, I purposely try to avoid giving too many options to avoid confusion. -Charles

George Bradshaw from NC posted over 12 years ago:

I like the concept of letting your winners run, but acknowledge that there needs to be some limiting criteria. My approach is to have no holdings below 1% or above 5%; my average is around 3%. Kind of like the 2.5 times criteria however. Bonds, gold, preferred stocks, cash is around 20% of my holdings; will add to bond positions when returns warrant.

Milt Misogianes from Delaware posted over 12 years ago:

To Joe A. from Cali - Such haughty words " sophomoric piffle" to describe article. Look at the highlight "For the Beginning Investor." Why don't you try and pen a financial article ? I have - some turned out popular and well done. Some did not. Rotblut's are typically articulate and based on academic research findings.

Milt Misogianes from Delaware posted over 12 years ago:

Addonazioni - have YOU written any sophomoric piffle lately ? Or are you just a wannabe ?

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