Position Sizing: Why So Serious?
Over the course of our multi-part series on position sizing, long-term readers will note that we’ve described a far more quantitative process than the more narrative driven descriptions we’ve offered for why we own the companies we do. This difference is driven by the type of decision making that informs what to own, versus the type of decision making needed to decide exactly when to place each trade.
In Part 4 of our series, we wrote:
“Annie Duke explained the need for decision makers operating under conditions of uncertainty and time pressures to align and reconcile what Kahneman called System One, or reflexive decision making, and System Two or deliberative decisions making.”
From Kahneman’s seminal book Thinking Fast and Slow:
“System 1 operates automatically and quickly, with little or no effort and no sense of voluntary control. System 2 allocates attention to the effortful mental activities that demand it. The operations of System 2 are often associated with the subjective experience of agency, choice, and concentration… The highly diverse operations of System 2 have one feature in common: they require attention and are disrupted when attention is drawn away… [But] System 2 has some ability to change the way System 1 works, by programming the normally automatic functions.”
We believe that System 2, deliberative decision making, is at the heart of analyzing companies. It is extremely time intensive to understand a business at a deep level, which is why we think (and the evidence strongly supports) that managing a focused portfolio of holdings is a key attribute of most successful fundamental, equity investing strategies.
But every day, the price of every position in our portfolio changes continuously. At the same time, news flow on our companies, their competitors, and the economy can influence our calculated fair values and our conviction ratings. In addition, we offer our investment strategy not only in the form of a mutual fund, but also as separately managed accounts, where cash inflows and outflows can impact the weight we have in each position we hold.
Compounding the need to make complex, continual judgments about specific buy/hold/sell decisions (the decision to do nothing and just hold is still a decision) is the fact that investors face significant cognitive biases. We believe that cognitive biases are more intense the closer you get to trade date. If you ask investors what they expect the market will do over long periods of time, they often will provide an estimate that is closely related to the historical base case of 8%-10% annualized returns. But under conditions of stress, investors’ time horizons shrink, causing them to make fundamentally mistaken forecasts due to a range of cognitive biases.
Recognizing that we need to make continual optimization decisions across multiple holdings and multiple portfolios and that these particular types of decisions are often clouded due to cognitive biases, we deconstructed our more standard, qualitative position sizing framework and designed the algorithm we’ve spent this series of posts describing.
This process builds on the research described in Roy Baumeister’s book Willpower, in which the author describes techniques to reconcile System 2 deliberative strategies you craft to reach your goals with the need to make in the moment decisions where System 1 reflexive processes take over.
“We often think of willpower in heroic terms, as a single act at a crucial moment in life… [But our] analysis of a large set of published and unpublished studies on people who scored high in self-control… [showed] the people with high self-control were distinguished by their behaviors that took place more or less automatically.”
In other words, by building an automatic position sizing formula, based on deep, deliberative thought to articulate what decisions we would want to make under all sorts of future conditions, we have created a system under which we can effortlessly, but relentlessly, stay true to our disciplined approach. At the same time, by handing off the cognitive load to an algorithm to decide things like “do we trim this stock at 6.5% or should we let it ride up to 7%?” or “do we buy now or after earnings?” we free up cognitive and attention resources to focus on deliberative System 2 processes that are key to uncovering alpha opportunities.
In many ways, the Ensemble Capital investment strategy is good old fashioned stock picking based on the qualitative judgments of human analysts. We use this process because we think it is superior to more quantitative approaches. But when it comes to tick by tick trade decisions and determining exactly how much of any stock we want to own in a portfolio, we think qualitative judgments become overwhelmed by cognitive biases.
We think we have a competitive advantage when it comes to assessing the long-term cash generation potential of companies. But when it comes to short term buy/hold/sell decisions in the context of rapidly moving prices and opportunity sets, we know that algorithms have humans beat and we’ll happily focus on designing and refining our algorithm instead. In doing so, we’ve made our best effort to follow Duke’s advice to “align and reconcile” System 1 and System 2 thinking.
Please click here for Part 6
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