Traders roundtable: how does position sizing compare to diversification as a risk management tool?
In a recent traders roundtable discussion, our talk came around to a discussion of two different risk management tools: position sizing and portfolio diversification. The question became: which one of these strategies is more effective?
The discussion led us to quickly reframe that question into one which said “how do both of these strategies, and others, allow us to develop a comprehensive risk management protocol for our trading strategies? First, a couple of definitions are in order.
Position sizing can be defined as a way to determine how many shares of your target to trade given your risk appetite, the size of your portfolio, your trade management skills, the market conditions, the normal and abnormal characteristics of the instrument your trading, the time of day, your mood at the moment of the trade, the robustness of your hardware and software systems and so on.
All of these factors taken together allowing you to establish an initial stop which will allow you to take a businessman is risk with your initial entry as expressed by dollars per share of initial risk. If you have done the calculus correctly, your average loss on losing trades should never exceed the amount you calculated your initial risk. If you discover that your average loss is greater than your initial risk over a statistically significant number trades, then there is some variable inside that list that you are improperly estimating and you are trading at too high a level of risk and therefore too large a position size for your trader quality number.
Portfolio diversification can be considered as the number of independent positions or piles of money that you will allocate into individual trades as a percentage of the total portfolio. Conventionally, we think of diversification as a poor man’s risk management by spreading the risk around we can expect to receive the average market return because things will tend to balance out. The greater the number of opportunities, the greater the likelihood that you will receive the average rate of return of the given system.
Taken together then we can think of position sizing as a tactical application of risk management to an individual trade that consider strategic variables when making specific decisions.
We can then think of portfolio diversification as a way to spread individual trade risk across a broad system in order to standardize our returns. This is more of an operational or strategic level policy decision whereas position sizing is a tactical application of risk management.
Our traders roundtable concluded that both of these working together should be more effective than either taken separately.
Blending them is sensible because they can be mutually supportive and effective trading strategies risk management process.