Why size is decided first
Most attention in investing goes to the question of what to buy. Comparatively little goes to how much. Yet the second question determines the consequence of being wrong, and being wrong some of the time is a certainty rather than a possibility.
Professional risk frameworks treat sizing as a constraint set before the idea is evaluated, not a variable adjusted afterwards. The reason is behavioural. Once a position is held, the temptation to add during a decline or to hold beyond the original thesis is strong. A rule decided in advance, when no capital is at stake, is easier to follow than one improvised under pressure.
A volatility-adjusted approach
One widely used method sets the size of a position so that a defined adverse move would cost a defined fraction of the portfolio. Suppose the rule is that no single position should be able to reduce the portfolio by more than one percent if it moves against you by the distance to your predetermined exit point.
If that exit is ten percent below the entry price, the position can be ten percent of the portfolio. If the exit is twenty percent below, because the security is more volatile and a tighter exit would be triggered by noise, the position can be five percent. The more volatile the security, the smaller the position, and the total risk to the portfolio stays constant.
The arithmetic is simple. Portfolio risk per position, divided by the distance to the exit expressed as a percentage, gives the maximum position size as a percentage of the portfolio. The discipline lies in doing the calculation every time and accepting the answer.
What changes when volatility rises
When market volatility increases, exit points need to be set further from entry to avoid being triggered by ordinary fluctuation. Under the method above, that automatically reduces position size. The portfolio takes less exposure to each idea precisely when the range of outcomes has widened.
This is the opposite of what many people do instinctively. Rising volatility often coincides with falling prices, which can look like opportunity, and the instinct is to increase size. A rule-based approach removes that decision from the moment and places it in the framework.
Limits of the method
Position sizing does not protect against gaps. A security can move through an exit point without trading at it, and the loss can exceed the planned amount. It also does not account for correlation. Ten positions each sized at one percent risk are not diversified if they all respond to the same factor.
These limits do not invalidate the approach. They are reasons to combine it with sector and factor exposure limits, and to treat the planned risk as a floor rather than a ceiling on what could go wrong. Sizing is one layer of a risk framework, not the whole of it.
Key points
What to take from this note
- 01Position size determines the consequence of being wrong, and being wrong sometimes is certain.
- 02Deciding size before entry removes the decision from emotionally difficult moments.
- 03A volatility-adjusted method reduces size automatically when the range of outcomes widens.
- 04Sizing does not protect against gaps or correlation, and should sit within a broader risk framework.
Goat Academy is an online financial education institution founded by economist and former investment banker Felix Prehn.
This article is general market commentary published for educational purposes. It is not financial, investment, or tax advice, is not a recommendation to buy or sell any security, and should not be relied upon as a basis for any investment decision. Trading and investing carry risk, including the loss of capital.