Yes, Size Matters

“Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money.” – Warren Buffett

Yes, size matters…for your investments (mind out of the gutter please).

One of the hardest determinations for investors to make is how much risk to take in their portfolio. There’s not a perfect definition of risk because it’s different for everyone depending on your personal situation.

In the world of finance people are always trying to quantify risk through complex models. Yet risk can’t always be converted neatly into a number.  There’s a difference between risk measurement and risk management.

Warren Buffett and Charlie Munger think of risk as a permanent loss of capital. In Buffett’s biography, Snowball, Munger described risk for long-term investors:

They defined risk as not losing money. To them, risk was “inextricably bound up in your time horizon for holding an asset.” Someone who could hold an asset for years could afford to ignore its volatility.

This long-term view makes the most sense to me, but investors must still be able to come up with an asset allocation plan that suits their ability and willingness to take risk.

One factor to consider when defining your risk profile is the size of your portfolio.

When you are young and just beginning to build up your savings you should be able to invest aggressively and take plenty of risk. Even if you lose 50% of your money in a given year, you will be losing a large percentage of a small amount.

Plus, you have a huge asset in your favor in called human capital or your future earnings power. You have the ability to continue to save as well as ride out periodic bear markets since you have a very long time horizon.

If you don’t need to spend the money for many decades, the day to day or even year to year movements in the markets shouldn’t really matter.

It’s also better to make your mistakes when you’re young and don’t have a large amount of money to deal with. With experience you can learn to minimize those mistakes.

So young investors have little size in their portfolio value but plenty of size in their time horizon to compound their savings.

As you age those variables will flip and investors approaching retirement have size in their portfolio (hopefully) but not nearly as much size in their time horizon.

This dynamic shifts your ability and need to take risk in in your portfolio depending on your spending constraints and plans for retirement. When you are older it will be harder to accept large percentage losses in your portfolio.

If you’re approaching retirement, you don’t have nearly as much time to make up a large loss through future savings.  If you need to spend your investment dollars for living expenses you don’t have the luxury of being patient with your entire portfolio to allow for a market recovery.

For example, a 40% loss on a $20,000 portfolio is only $8,000. Young investors can make that up through a combination of future contributions and patience by staying invested and ride out the storm.

On the other hand, a retiree with a $1 million portfolio that loses 40% would see a loss of $400,000 without the benefit of future savings.

Jason Zweig shared an interesting study in Your Money and Your Brain that looked at investor perception of gains and losses to put this into perspective.

In the study, the investors who focused on changes in price levels earned between five and ten times more profit than those who focused on price changes in percentage terms.

Also, those that focused on absolute price levels held their investments for the long-term while the percentage-focused investors traded more often to take gains and shed losers.

This idea of magnitude applies to individual investments as well. Many investors want the easy way out. That’s why we are constantly on the lookout for the next hot IPO, merger deal or penny stock that will be sure to lead to quick riches.

What most investors don’t realize is that to make this lottery ticket approach work it’s not enough to choose the investment that goes up by a large amount in price. You must also be willing to make a wager in size to make a difference.

This is what Michael Mauboussin has termed the Babe Ruth Effect.

The Babe struck out on a regular basis, but he was still one of the greatest home run hitters of all-time. He made up for his strikeouts by hitting it out of the park when he did make contact.

It doesn’t necessarily matter how often you are right when picking stocks. What matters is the magnitude of the investment you make when you are right or wrong.

This is what makes Buffett such a great investor. When he thinks he has found a stock with a high probability of success, he makes sure that it will move the needle by investing a large chunk of capital.

But he’s never looking for a quick score. His investment time horizon is potentially forever. And he’s willing to wait for the proverbial ‘fat pitch’ until he makes an investment.

You don’t hear about Buffett betting on stocks he thinks will go up in the next week, quarter or year. He’s looking years into the future for his holding period.

So there you have it. I have scientifically (well, sort of) proven that size does matter…when building wealth.

Sources:
Your Money and Your Brain
More than You Know