Position Sizing: The Most Overlooked Skill in Investing

Ask a hundred investors about their best stock pick, and they'll talk for an hour. Ask those same investors about their position sizing methodology, and you'll get blank stares. This asymmetry explains why many investors pick great stocks but still deliver mediocre portfolio returns.

Position sizing — determining how much capital to allocate to each investment — is the bridge between having good ideas and making good money. A 100% return on a 1% position adds one percentage point to your portfolio. The same 100% return on a 10% position adds ten percentage points. The stock selection was identical; the outcome was ten times different.

The Kelly Criterion, developed by John Kelly at Bell Labs in 1956, provides a mathematical framework for optimal position sizing. The formula is simple: the optimal bet size equals your edge divided by the odds. In investing terms, if you believe a stock has a 60% chance of rising 50% and a 40% chance of falling 30%, the Kelly formula suggests betting approximately 27% of your capital.

In practice, no serious investor uses the full Kelly bet. The estimates of probability and payoff are too uncertain. Most practitioners use "half Kelly" or "quarter Kelly" — betting one-half or one-quarter of the mathematically optimal amount. This reduces the volatility of returns while still concentrating capital on the best ideas.

Buffett's approach to position sizing is instructive. Despite managing hundreds of billions, Berkshire Hathaway's equity portfolio is remarkably concentrated. Apple alone has represented over 40% of the portfolio at times. This isn't recklessness — it's a deliberate strategy. When you find a genuinely exceptional opportunity that falls squarely within your circle of competence, sizing it meaningfully is the rational choice.

But concentration requires conviction, and conviction requires thorough analysis. The typical retail investor who puts 30% of their portfolio in a single stock based on a tip from a friend is not following Buffett's approach. They're gambling. The difference is the depth of understanding behind the position.

A practical position sizing framework has three tiers. Tier one is your highest-conviction ideas — businesses you understand deeply, trading at significant discounts to intrinsic value. These might represent 8-12% of your portfolio each. Tier two is strong ideas with somewhat less conviction or less attractive valuations — perhaps 4-7% each. Tier three is smaller positions in early-stage research or more speculative opportunities — 1-3% each.

The total number of positions matters too. Studies by academic researchers and practitioners suggest that 80-90% of diversification benefits are captured with 15-25 positions. Beyond that, each additional position dilutes the impact of your best ideas without meaningfully reducing portfolio risk.

Risk management through position sizing also means having rules for when positions grow. If your 8% position doubles and becomes 14% of your portfolio, do you trim? This is where pre-set rules become invaluable. Some investors rebalance at fixed thresholds. Others let winners run but set maximum position sizes at 15% or 20% of the portfolio.

One critical mistake is equal weighting. Allocating the same amount to every position regardless of conviction level means your best idea and your worst idea receive identical capital. This is intellectually lazy and mathematically suboptimal. Your portfolio should reflect your conviction hierarchy.

Stanley Druckenmiller, one of the most successful macro investors in history, put it bluntly: "The way to build long-term returns is through preservation of capital and home runs. When you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig."

At KeepRule, we help investors document and track their position sizing rules alongside their buying and selling criteria. The discipline of writing down "I will size high-conviction positions at 8-12%" and then reviewing whether you actually followed that rule creates accountability that dramatically improves capital allocation over time.

The next time you find a great investment idea, don't just ask "should I buy it?" Ask "how much should I buy?" The answer to the second question will determine far more of your long-term wealth than the answer to the first.