Diversification and Position Sizing

6 September 2017


There is an old saying that diversification is the only free lunch on Wall Street. Most investors
know the benefits of and practice diversification. It is one of the great advantages that stock
market has over other forms of investing, you can achieve diversification quickly and cheaply.

While there is no magic number, most investors do not want to be overly concentrated in their
portfolios (1 or 2 stocks) and at the same time do not want to be too diversified (25+ stocks).
Most investors also know that it is important to be diversified across different industries or
sectors. For example, if you own 10 airline or 10 gold stocks are you really diversified?

Investors rarely consider position sizing as a factor when looking at diversification. In this article, we will
look at position sizing and its importance when looking for true diversification.

The easiest way to do this is to create a portfolio. For this example, we have assumed
an account balance of $50,000 and selected 10 reasonably well known stocks that are
listed on the NZX. The account balance is not that relevant and the stocks have been
selected for illustrative value rather than any assumption of merit. Many investors will
typically allocate capital through “fixed fractional position sizing”. This essentially
allocates capital evenly across each listing. The prices below are correct as of the 5th
of September 2017 and will be out of date by the time you read this but are largely
irrelevant to the illustrative purposes of this article.

Through fixed fractional position sizing the above table allocates capital evenly,
allowing a 10% weighting to each position. What this allocation does not take into
consideration is volatility. The downside of fixed fractional position sizing is that each
stock is allocated the same percentage regardless of volatility. The result is that the
more volatile holdings in your portfolio will dominate its performance either to the
upside or the downside. This is absolutely fine if it is what your intending, but can lead
to investors scratching their heads if it is unintentional.

To be truly diversified investors need to account for volatility. It does not need to be
an exact measure but being close enough is usually fine. We have reformulated the
above portfolio to take into consideration volatility. Each stocks weighting is calculated

through using historical volatility. The consequence of this is that the impact of each
of these stocks on the overall portfolio is the same. Please see updated table:

Based on historical volatility the allocation across the same stocks looks significantly
different. For example, a 13.57% allocation of Tourism Holdings will have the same
impact on your portfolio as a 6.04% allocation of A2 Milk. While you would need over
20% of Mainfreight to have the same impact as a 4.27% allocation in Moa Group.

When using fixed fractional position sizing the more volatile issues such as Moa Group,
Orion Health and A2 Milk will likely dominate the overall performance of your portfolio.
As mentioned earlier, this is fine if it is intentional, but position sizing should be
considered by investors seeking to find diversification.

In summary, you may want to consider how risky/volatile a stock is and adjust your
portfolio weighting accordingly.

Please note that historical volatility is not a measure of future volatility and allocations
can change.

More to diversification than meets the eye

Do You Want Daily Market Insights?

If you’re interested in staying up-to-date with the latest news and analysis on stocks, be sure to sign up to BlackBull Research.

1 Month Free Trial

Access our expert stock market research Free of charge with no obligation

Free 1 Month Free Trial

Unlock this article & access our expert stock market research

ASX, NZX & USD Stock Buy, Hold, Sell recommendations. Model Portfolios. Daily news and more

[pmpro_checkout]