Chapter 04

Building & Managing a Portfolio

Finding good trades is only half the battle. How you combine them into a portfolio — and how you size each position — determines whether you make money or blow up. This chapter covers portfolio construction from a practical trading perspective.

Why Portfolio Thinking Matters

A trader who puts 100% of their capital into one stock is gambling. A trader who spreads capital across uncorrelated positions is building a portfolio. The difference:

  • Single position: One bad earnings report and you lose 30%
  • Diversified portfolio: One position drops 30%, but it's only 5% of your book, so the total impact is -1.5%
Diversification is the only free lunch in finance. Uncorrelated positions reduce portfolio risk without reducing expected return.

Correlation: The Key to Diversification

Two stocks that move together provide no diversification benefit. Correlation ranges from -1 to +1:

  • +1.0: Move in perfect lockstep (e.g., SPY and VOO). No diversification.
  • 0.0: No relationship. Ideal for diversification.
  • -1.0: Move in opposite directions. Perfect hedge.

In practice, correlations between stocks range from 0.3 to 0.8. During market crashes, correlations spike toward 1.0 — everything drops together. This is when diversification is most needed and least effective.

Position Sizing

Position sizing is arguably the most important decision in trading. It answers: “How much of my capital do I put into this trade?”

Fixed percentage risk

The most popular approach: risk a fixed percentage (typically 1-2%) of your total capital on each trade.

Position Size = (Account × Risk %) ÷ (Entry Price − Stop Loss)

Example: $100,000 account, risking 1% ($1,000) per trade. Stock at $50 with a stop at $48 (risk of $2 per share). Position size = $1,000 ÷ $2 = 500 shares ($25,000 position).

Volatility-based sizing

Size positions based on how volatile the stock is. A volatile stock gets a smaller position; a stable stock gets a larger one.

Position Size = Target Risk ÷ (ATR × Multiplier)

This equalizes risk across positions — a stock that moves 5% daily gets a smaller allocation than one that moves 0.5% daily.

Portfolio Allocation Models

  • Equal weight: Give each position the same dollar amount. Simple, but doesn't account for volatility differences.
  • Risk parity: Allocate so each position contributes equal risk to the portfolio. Volatile assets get less capital.
  • Conviction weighting: Size positions based on signal strength. Higher-confidence trades get more capital. Requires disciplined signal scoring.
  • Sector limits: Cap exposure to any single sector (e.g., no more than 25% in tech). Prevents hidden concentration.

Measuring Portfolio Performance

  • Total return: What you made. Important but incomplete — doesn't account for how much risk you took.
  • Sharpe ratio: Return per unit of risk. Above 1.0 is good, above 2.0 is excellent.
  • Max drawdown: The worst peak-to-trough decline. -20% means at some point you were down 20% from your highs.
  • Win rate: Percentage of trades that were profitable. A 40% win rate can be very profitable if winners are 3x larger than losers.
  • Profit factor: Total gross profit ÷ total gross loss. Above 1.5 is solid.
Sharpe Ratio = (Portfolio Return − Risk-Free Rate) ÷ Portfolio Volatility

Rebalancing

Over time, winning positions grow and losers shrink, distorting your intended allocation. Rebalancing restores the target weights. Options:

  • Calendar-based: Rebalance weekly, monthly, or quarterly — simple and disciplined
  • Threshold-based: Rebalance when any position drifts more than a set % from target
  • Signal-based: Reallocate when the underlying signals change — most responsive

Practical Rules

  • Never risk more than 1-2% of your account on a single trade
  • Keep total portfolio heat (sum of all position risks) under 6-10%
  • Avoid putting more than 20-25% in any single sector
  • Track correlation between your positions — they may be less diversified than you think
  • Size positions before you enter, not after