Position sizing refers to the parameters that dictate how much capital you allocate to a given trade, and how that relates to the level of risk you take one each trade, and how those factors affect your total account size.
There are several factors that play into developing a position sizing methodology. The first is the size of your trading account. As your account size grows, you will generally risk a smaller percentage of your account on each trade.
Why Position Sizing Might Be The Key to Your Success
A 1991 Journal of Finance study by Brinson, Singer & Beebower came to a shocking conclusion about the importance of position sizing. The study is called Determinants of Portfolio Performance II: An Update and it found, among other things, that position sizing accounted for 91% of portfolio performance.
Here’s what study’s abstract had to say about the findings:
Data from 82 large pension plans indicate that asset allocation policy, however determined, is the overwhelmingly dominant contributor to total return. Active investment decisions by plan sponsors and managers did little on average to improve performance over the 10-year period December 1977 to December 1987.
In layman’s terms, the study found that the size of various positions within a portfolio, rather than choosing the right individual securities or timing the market, was by and far the most influential factor to a portfolio’s returns.
Of course, there is the caveat here that these are large pension funds deploying an asset allocation strategy. They’re all generally within the same assets, so there’s a lot of overlap between their portfolios, making the differences like their position sizing more pronounced. So, it’s unlikely that position sizing alone is responsible for 91% of a price-action trader’s returns, however the number is still probably quite high.
In both the investing and trading world, the overwhelming focus is on clever, active tactics performed by individuals. In the investing world, managers are credited for finding a security that is undervalued by the market, traders are credited for finding that golden setup. But, over a larger time-frame, the impacts of these individual decisions are reduced drastically.
As this study shows, more attention should be paid to position and risk management, with sound trading strategy acting as a filter for choosing trades to take.
This study was brought to my attention by trading coach Van Tharp, who refers to position sizing as the second most important trading skill to have, behind trading psychology. Tharp developed his own position sizing game which he plays with the attendees of his seminars.
In the game, he gives all the players the same trades to take, and in his words “we’ll probably have as many equities as there are attendees.” When he says equities,’ he is referring to equity curves, not different equity securities.