How to build an investment position

TL;DR: If you want to build an investment position in a new stock or asset class, you need to figure out how much and how quickly to invest. With stocks, try to limit investment in any single company to 1% of your net worth, and aim to invest that amount in three phases over time, giving you the chance to validate your investment thesis and limit your downside risk. A similar approach can be taken with real estate or other asset classes. This measured approach will help you reduce risk, make better investment decisions, and sleep well at night.

When I first started investing I struggled with the question of how to build up an investment position in a particular stock or asset class. My initial approach was to figure out how much I could afford, and then pull the trigger all at once. When an investment started going against me, I felt helpless. I had a large exposure, and the only action I could take was to hold or sell. I’ve since found a better way that reduces risk, makes better investment decisions, and helps me sleep at night.

As opposed to going ‘all in’ on an investment, I take a more measured approach. I build up a position in an investment in three phases over time. This phased approach helps me limit downside risk, while giving me some ‘skin in the game’ to force me to think more clearly about the investment prospects.

Let’s look at an example

Let’s say I want to buy Apple stock. The next step is to figure out how much Apple stock I eventually want to own. As I outlined in my 9 investment rules to live by, I typically aim for no more than 1% of my liquid net worth tied up in any particular stock – so if I have $1M in liquid net worth, the most I would want to own of any single stock would be $10K. Now, to build that position in Apple, I’ll make an initial investment of ~1/3 of my target position. In this case: ~$3,500. The next step is to wait. Give it some time. I’ll continue with my diligence of the company. I’ll think about how I feel now that I own a piece of the company. I’ll watch the stock price to see what the market thinks. At this point one of two things can happen, the investment will go up, or it will be flat to down.

What to do when your investment goes up

Let’s assume your initial position goes up by 20%. Assuming you’re still bullish on Apple, this is a good time to double down. Take another 1/3 of your target allocation ($3,500) and buy some more. Then repeat the cycle. Give it some time. Revisit your investment thesis and make sure it still holds. Follow the market price. If the underlying prospects for the company continue improving, and the stock price responds accordingly, you can finish off your investment by adding the remaining ~$3,500 to your position. At that point, you’ll have the full exposure you wanted to Apple stock, along with a nice cushion of profit from the gains on your earlier purchases. If things start turning against you and you believe prospects have changed for Apple, then you can probably get out of the trade with a small gain or at most a small loss. Ideally, of course, Apple has a bright future, and the only thing left for you to do is hold on for the next several decades and let the employees turn it into an increasingly valuable asset for you!

What to do if your investment is flat or down

Of course, the market doesn’t always go your way. Sometimes there will be a general market decline. Maybe Apple will miss their numbers. In any of these situations, it’s possible your initial position will decline in value. At this point, you need to reassess your investment thesis. If your thesis no longer holds, then you might consider bailing out of your Apple investment and taking a small loss. Better to cap your downside with a small loss than to let that loss grow into a big one. But, if you still believe in the future of Apple, then you should actually buy more! If the underlying value of the asset hasn’t changed, but the market wants to sell it to you for less, you should be happy. Never mind that the initial investment of $3,500 is down a little, this could present a great opportunity to buy more on the cheap. Every time it goes down, it becomes more of a bargain as long as your view of prospective returns remains the same. What you want to do at this point is invest another 1/3 of your target investment amount ~$3,500. Then repeat the process. Give it some time. Follow the company. Follow the market. If the stock starts making a recovery and you’re still bullish about Apple, that might signal the right time to put the remaining $3,500 down. But, if things continue to decline, you’ll have to do some soul searching. How strongly do you believe in the business? At this point, the market is telling you that they don’t share your thesis. Do you have an edge or a point of view that tells you the market is wrong? Getting out at this point is tough, but could be worth it if your investment thesis has changed. Of course, if you did your diligence up front and really like the company, then you might want to hold on. Weather the storm. Stocks can trade in weird directions for longer than you would think, only to bounce back toward their intrinsic value when you least expect it. In my case, if I’m still bullish on the company, I’ll often hold on and bide my time. If I’m really bullish, I might consider putting the remaining $3,500 to work – but that would require high conviction on the future prospects of the company.

This is why it’s so important to invest in things you know really well. Only if you know the value and prospects for a company will you be able to maintain conviction in the face of a market decline. The hardest time to buy more stocks if often right when your current portfolio has taken a hit. Yet, oddly, this is also often the best time to be loading up on, as long as you’ve done your diligence properly.

The benefits

To sum things up, this approach achieves a few things for me:

  1. Sleep at night – first, and foremost, it helps me sleep at night. Investing can be stressful. I worry constantly about losing money. With this strategy, you’re able to enter into an investment position gradually over time. If things go well from the beginning, you’ll slowly build your position and maintain a nice cushion to protect from market declines. If things go poorly, you’ll limit your exposure, and be able to bail out with limited damage. Your risk is managed, so you’ll be able to sleep soundly at night.
  2. Forces clear thinking – I find this approach really helps me crystallize my thinking on an investment. Despite my best efforts, I often don’t think as deeply or clearly about a company or stock until I actually own a little. Making a purchase, forces you to have some skin in the game. It will force you to think about how you feel, helping you to surface any reservations you might have.
  3. Double down on winners, cull the losers – lastly, great investing is about sticking with the winners over time, and limiting the damage from the losers. This approach helps to cap the downside from bad bets, while giving you the chance to build a full position in a great company over time. The best companies will hopefully grow 5-10X over the next 5-10 years, so missing 10 or 20% of upside in the beginning is a small price to pay for picking and sticking with the real winners.

Great investing is as much about controlling your emotions and psychology, as it is about having a brilliant investment thesis. This approach to investing helps me to manage the fearful parts of my nature, while using ‘skin in the game’ to force clear thinking. It gives me a chance to limit the downside, while still capturing the majority of the upside. Perhaps most important of all, it helps me sleep at night, and that is truly priceless. This approach works best with publicly traded stocks, but you can apply these principles to any investment class (i.e. real estate). Try it out with your next investment and see how it works for you.

Enjoy!

Ramen-san

Leave a Reply