Position sizing is a critical component of investment portfolio management, as it determines the amount of capital allocated to each investment. Fixed-fractionalvolatility targeting and fractional Kelly are three popular position sizing approaches used to optimize portfolio performance. In this article, we will explore each approach in depth and discuss their implications for compound annual growth rate (CAGR) and maximum drawdown.
The fixed-fractional approach involves allocating a fixed percentage of the portfolio to each investment. This approach is simple to implement but may not account for changes in market volatility. The volatility targeting approach, on the other hand, involves adjusting the position size based on the investment’s volatility. This approach can help to reduce risk but may also reduce potential returns.
Volatility Targeting Approach
The volatility targeting approach involves setting a target volatility level for the portfolio and adjusting the position size accordingly. For example, if the target volatility is 10%, the position size would be adjusted to achieve this level of volatility. This approach can be implemented using a volatility scaling method, where the position size is scaled based on the investment’s volatility.
Fractional Kelly Approach
The fractional Kelly approach involves allocating a fraction of the optimal Kelly bet size to each investment. The Kelly criterion is a formula for determining the optimal bet size based on the probability of winning and the payoff odds. The fractional Kelly approach can help to optimize portfolio performance but requires accurate estimates of the investment’s probability of winning and payoff odds.
Impact on CAGR and Maximum Drawdown
The position sizing approach used can have a significant impact on the portfolio’s CAGR and maximum drawdown. The fixed-fractional approach may result in higher CAGR but also higher maximum drawdown, while the volatility targeting approach may result in lower CAGR but also lower maximum drawdown. The fractional Kelly approach can help to optimize CAGR while minimizing maximum drawdown.
To illustrate the impact of position sizing on CAGR and maximum drawdown, consider a portfolio with two investments: Investment A with a 10% expected return and 15% volatility, and Investment B with a 12% expected return and 20% volatility. Using the fixed-fractional approach, the portfolio may allocate 50% to each investment, resulting in a CAGR of 11% and a maximum drawdown of 15%. Using the volatility targeting approach, the portfolio may allocate 40% to Investment A and 60% to Investment B, resulting in a CAGR of 10.5% and a maximum drawdown of 12%. Using the fractional Kelly approach, the portfolio may allocate 30% to Investment A and 70% to Investment B, resulting in a CAGR of 11.2% and a maximum drawdown of 10%.
Practical Implementation
To implement these position sizing approaches in practice, investors can use simple calculators and heuristics. For example, the volatility scaling method can be implemented using a spreadsheet or programming language. The fractional Kelly approach can be implemented using a Kelly criterion calculator or a programming language. Investors can also use portfolio optimization software to implement these approaches and optimize their portfolio performance.
