Transaction sizes are a component of basic execution in a financial market investment portfolio. But the choice of transaction size seems to be misunderstood and sometimes flawed.
Most investors decide their transaction size subconsciously. Usually, it’s connected to the dollar value of the account, representing a division of capital within that account. It’s part of the broader approach to diversification.
However, the practices used to accomplish diversification by many retail investors are not based on facts or the realities of managing a portfolio. Here’s why.
The Realities of Diversification
Diversification is intended to reduce risk. The standard measures of risk are based on security behaviour but they do not account for the actions taken by the investor. This is where effective diversification becomes muddled and potentially flawed. The biggest issue related to diversification and transaction size is the ability to manage the total number of positions.
Let's use an example of a smaller portfolio. Investors with $10-$12K accounts may decide to purchase three or four stocks or E.T.F.'s. The intention is to minimize the negative impact from an over weighted security in the portfolio. But here are the problems in this particular example.
The decisions made on buys are likely the same for all securities. Accordingly, poor buying practices still affects the entire account regardless of how the capital is carved up (by transactions).
When a broader market correction starts, investors may follow the practice of selling one stock or E.T.F. and then waiting to see what happens. Within a short time, they recognize selling was the right thing to do so one more security may be sold. But then the investor waits again only to subsequently realize they were late selling the remaining positions. The response then is to hold remaining positions. 50% or more of the portfolio remains exposed to falling prices.
The same result can occur in any sized portfolio. Investors who buy a large number of securities will suffer the same fate as selling a large number at once seems extreme. But the portfolio size is the constant in managing successfully, not the number of holdings.
Let's work through this issue a different way. Suppose an investor with a portfolio of $10-$12K bought only one stock or E.T.F. The first reaction is fear! What if it goes down? The only difference between holding one versus four or more securities in this portfolio is the emotional response. With numerous securities, investor may not react to the fact a portion of the portfolio is going the wrong way.
How To Invest For Success
Investors who are relatively inexperienced are in an interesting position. Like someone starting to play a sport or game, what matters isn't the outcome so much as the process of learning to play better. Investors who hold just one security, in a smaller account, may benefit more in the long run by forcing themselves to manage better.
Buying right avoids losses and selling when a downtrend starts are the keys to success. How the pie is carved up is largely irrelevant.
Keeping the number of positions down rarely compromises diversification. There are very few investors who actually suffer from failing to diversify sufficiently. Concentrating capital in markets and securities that are rising is, in the real world, less risk not more.
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