How to Size Your Portfolio to Fit

I've written two columns already about "spring cleaning" a portfolio, walking you first through the criteria I use when reshaping my holdings and then through the stocks and decisions those criteria pointed to. But there's one aspect I didn't cover: What's the best way to size positions for a long-only equity portfolio?

In order to answer this question, I use the Kelly criterion (popularized in the excellent book Fortune's Formula), which says that a position size should be equal to (edge/odds). Edge is the excess return that you expect to earn on average. Odds describes the likelihood of winning. A 50/50 bet makes odds equal to 1.

There is added complexity in applying this to stocks, because in gambling, each game is (mostly) uncorrelated with the last one. In investing, if you have a number of investments going at the same time, they are to some degree correlated with one another.

That's particularly true for me, because I concentrate sectors. I believe that my portfolio acts more like a portfolio with half the number of positions because of the correlatedness of the various names in the portfolio. Thus, the 35 names in my portfolio behave more like 18 uncorrelated names.

The Kelly criterion applied to stock investing would recommend a fixed-weight portfolio. Optimally, you would rebalance daily to those fixed weights. But two factors interfere: First, there are costs to trading, and second, momentum tends to persist in the short run.

To me, those realities mean that you can have fixed weights, but that you set a band around those fixed weights for rebalancing. I use a 20% band, but the more I think about it, the band should be smaller, maybe 10%. My portfolio has gotten bigger over the past few years, and trading costs are a smaller-percentage cost factor. I'll stick with 20% for now. It has served me well, but I will re-evaluate this.

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.

Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.