Skip to main content

Position Sizing: How Much to Invest in Each Stock

🌟 Sizing Your Bets: An Introduction to Position Sizing​

You've decided on your asset allocation and you understand the importance of diversification. Now you're faced with a critical question: when you decide to buy a stock, how much should you buy? This is the art and science of position sizing. It's a risk management technique that determines the appropriate amount of capital to allocate to any single investment. While finding a great company is important, correctly sizing your position is arguably even more critical. A winning stock that's too small a position won't help you much, and a losing stock that's too large can wreck your entire portfolio.

The Philosophy: Control Your Risk Before You Enter a Trade​

The core philosophy of position sizing is to shift your focus from "How much can I make?" to "How much can I lose?" It's a proactive approach to risk management. Before you even buy a stock, you should determine the maximum amount of your total portfolio you are willing to risk on that single idea.

By systematically controlling the size of your positions, you ensure that no single investment can ever deal you a catastrophic blow. It's the key to surviving the inevitable losses that every investor experiences and staying in the game long enough for your winners to compound. A great stock-picker with poor position sizing will eventually go broke, while a mediocre stock-picker with excellent position sizing can still build significant wealth.

Common Position Sizing Models​

There are several methods for determining how to size your positions. The right one for you depends on your strategy and risk tolerance.

  1. The Fixed Percentage Model: This is the most common and straightforward approach. You decide to risk a fixed percentage of your total portfolio on any single trade, typically between 1% and 3%. For example, if you have a $100,000 portfolio and a 2% risk rule, you would not allow yourself to lose more than $2,000 on any single investment.
  2. The Fixed Dollar Amount Model: In this model, you simply assign a fixed dollar amount to each position. For example, you might decide that every stock you buy will be a $5,000 position, regardless of your total portfolio size. This is simple to implement but doesn't adapt as your portfolio grows or shrinks.
  3. The Kelly Criterion: This is a more complex, mathematical formula used by professional traders and gamblers. It calculates the optimal position size based on the probability of a trade winning and the expected win-to-loss ratio. While powerful, it can be difficult to implement for stock investing, as the probabilities are not as clearly defined as they are in a game of cards.

Putting It Into Practice: Position Sizing with a Stop-Loss​

The most effective way to use the fixed percentage model is to combine it with a stop-loss order. A stop-loss is a pre-set order to sell a stock if it falls to a certain price. This defines your exact exit point and your maximum potential loss before you even enter the trade.

Here's the formula: Position Size = (Total Portfolio Value x Risk %) / (Entry Price - Stop-Loss Price)

Example:

  • Total Portfolio Value: $100,000
  • Max Risk %: 2% (or $2,000)
  • Stock Entry Price: $50
  • Stop-Loss Price: $45 (a 10% drop)

Calculation:

  • Max Dollar Risk: $100,000 * 0.02 = $2,000
  • Risk Per Share: $50 - $45 = $5
  • Number of Shares to Buy: $2,000 / $5 = 400 shares

So, your position size would be 400 shares, for a total investment of $20,000 (400 x $50). If the stock hits your stop-loss at $45, you will be sold out of your position for a loss of exactly $2,000, which is 2% of your portfolio.

The Dangers of "Averaging Down"​

Position sizing forces a disciplined approach that stands in stark contrast to a common mistake made by novice investors: averaging down. This is the practice of buying more of a stock as its price falls, in the hopes of lowering your average cost.

Without a clear position sizing rule, averaging down can be incredibly dangerous. It violates the core principle of risk management: you are increasing your exposure to a losing position. A disciplined investor with a position sizing strategy cuts their losers short and lets their winners run. An investor who averages down is often throwing good money after bad, turning a small, manageable loss into a catastrophic one.

Position Sizing for Long-Term Investors​

Some long-term, buy-and-hold investors might argue that position sizing and stop-losses are for short-term traders. While they may not use a hard stop-loss order, the principle of position sizing is still critical.

For a long-term investor, position sizing might be simpler. For example, you might decide that no single stock will ever account for more than 5% of your total portfolio value. If you have a portfolio of 20-30 stocks, this is a natural outcome. If one of your stocks is a huge winner and grows to become 15% of your portfolio, a disciplined position sizer would trim that position back down to their 5% limit, locking in some profits and reallocating the capital to other opportunities.

💡 Conclusion: Your Ultimate Defense Mechanism​

Position sizing is the single most important skill for managing risk and preserving your capital. It's the difference between being a disciplined investor and a gambler. By determining your maximum acceptable loss before you invest, you take control of your portfolio and protect yourself from the emotional decisions that so often lead to financial ruin. Mastering position sizing ensures that you can survive the inevitable downturns and stay in the market long enough to build lasting wealth.

Here’s what to remember:

  • Define your risk first. Before you think about how much you can make, decide the absolute maximum you are willing to lose on a single investment.
  • Use a consistent model. Whether it's a fixed percentage or a fixed dollar amount, apply your position sizing rules consistently to every investment.
  • Combine position sizing with stop-losses. This is the most effective way to enforce your risk management discipline.
  • Never average down on a losing stock. This is a violation of sound position sizing principles.

Challenge Yourself: Assume you have a $50,000 portfolio and you've decided on a 2.5% maximum risk per trade. You want to buy a stock that is currently trading at $100, and you plan to set your stop-loss at $90. How many shares of the stock should you buy?

➡️ What's Next?​

You've learned how to size your positions to control risk. But what happens when your winning positions grow and your losing positions shrink, throwing your carefully planned portfolio out of balance? In the next article, we'll discuss the essential maintenance task of "Portfolio Rebalancing: Keeping Your Portfolio on Track."

You've learned how to place your bets. Now, let's learn how to maintain the table.

📚 Glossary & Further Reading​

Glossary:

  • Position Sizing: The process of determining how many shares or units of a particular security to purchase, based on the investor's risk tolerance and account size.
  • Risk Management: The process of identifying, assessing, and controlling threats to an organization's capital and earnings.
  • Stop-Loss Order: An order placed with a broker to buy or sell a specific stock once the stock reaches a certain price.
  • Averaging Down: An investment strategy that involves an investor buying additional shares of a previously initiated investment after the price has dropped.

Further Reading: