Updated: Jan 11, 2021
One behavior that can destroy investment results and ruin months, and maybe even years, of hard work, is destructive sizing decisions.
Imagine you have a game plan on a stock that is currently trading at $100. You buy-in and it immediately drops to 90 dollars. Being the shrewd investor you are, you see the “bargain” right in front of you, so you send in an order to double down and buy twice as many shares.
After a few months, the stock seems to stabilize and is set to report earnings. To your horror, the report comes out and the stop, the stock gaps down and open at $60. At this point, you take all your available cash and rapidly enter at any price, just to get your average price closer to the current price.
People are beholden to an original idea and double down on it despite evidence that they should just cut their losses and retreat. Destructive sizing decisions are based on the idea that position sizing is based upon subjective judgment with many factors at play. Some of these factors include timing, the previous experience an investor has and an investor’s emotional capability to name a few.
This losing proposition throws your risk management principles out the door. This example illustrates how destructive sizing decisions can turn a small loss into a large loss.
How can you avoid falling into this trap?
Destructive sizing decisions are usually the product of three main behaviors: overconfidence, fallacy of knowledge, and risk aversion. Knowing a bit about these might help you catch yourself from falling into one of their traps.
Overconfidence is just what it sounds like – too much confidence in your stock selecting abilities, or your portfolio’s potential performance. Like this little Sumo. One should remain objective when assessing their abilities, which may require vetting ideas with someone else who isn’t subjective.
Upping your size is wrong when it is not within your plan. The best way to combat upping your size at the wrong moment is through proper risk management. If it is not in your mind when you create a game plan, you should avoid spontaneous upping/lowering your sizing at all costs.
Create a written game plan that identifies how much you want to allocate to each investment, how long you plan to hold, and when you plan on exiting. This will be vital for your investment longevity. Most importantly – stick to it.
Fallacy of Knowledge
Fallacy of knowledge occurs when you believe your expertise and efforts in studying the market will help you predict the market. Unfortunately, the reality is that no one can predict the markets consistently, even with an advanced degree or years of experience. In fact, wealth managers – people who are literally paid to predict the market – performed worse than the S&P 500 for the past 9 years. History showcases that even the best fund managers cannot consistently outperform the indexes.
No one has a crystal ball. To protect against the fallacy of knowledge an investor can keep risk consistent in all trades.
Risk aversion means you play it too safe in order to avoid potential losses. This scaredy-cat mentality can lead to improper asset allocation in your portfolio, which is a kind of destructive sizing decision.
For example, younger investors should own more stocks than bonds, because they have the advantage of time to let assets grow. However, a risk-averse investor will place a large chunk of money into bonds and will not reap the full benefits of compounding.
The following chart shows the performance of the S&P 500 minus the performance of 5-year treasuries for a 15-year period. Stocks outperformed treasuries for the most part.
All in all, size can skew your portfolio returns dramatically. You need to have a written game plan about how you plan on allocating your capital, and a way to size the trades you make. Something to keep you honest to yourself and making decisions void of over or under exuberance.