Asset allocation More positions don’t always equal more diversification

You probably spend a lot of time deciding what to own. But you may not be spending as much time determining how much of a particular investment to own. A common belief is that adding more positions automatically improves diversification. Position sizing is often the difference between a portfolio that reflects conviction and one that simply collects holdings. In reality, some positions may be so small that they contribute virtually nothing to portfolio outcomes.

All positions aren’t created equal

Position sizing should depend on the portfolio’s investment strategy. For example, consider four different investments with the same 2% position size. (See table below.)

Think in risk, not just dollars. You may be allocating portfolio investments based on capital. A more effective approach can often be to think of an allocation in terms of risk contribution.

As the table above shows, the results vary:

• A 2% position in an artificial intelligence (AI)-focused thematic ETF may have more influence on portfolio performance than a 10% position in a diversified large-cap blend fund.
• A 2% allocation to a core bond fund may have almost no measurable impact on either returns or risk.
• A diversified stock strategy with low tracking error may need a 10%–20% allocation to meaningfully express an investment view.

A key thing to consider is tracking error, which measures how much a strategy tends to deviate from its benchmark. Higher tracking error can mean a wider range of potential outcomes, both positive and negative. Consider this example. If excess return = +1% and tracking error = 4%:

• Tracking error ±1: Approximately 68% of the time the excess return = -3% to +5%
• Tracking error ±2: Approximately 95% of the time the excess return = -7% to +9%
• Tracking error ±3: Approximately 99.7% of the time the excess return = -11% to +13% 

A concentrated thematic ETF or individual stock can materially influence results even at a small weight. A traditional core bond fund, by contrast, may require a much larger allocation before its performance meaningfully moves overall portfolio returns.

So, a useful question to ask: "Will this position actually matter?" not "Should I own it?" A small position with a high tracking error can make a big impact, but a small position with a low tracking error can have very little impact.

Practical position sizing guidelines

In practice, position size should reflect each investment’s potential to affect overall portfolio behavior — not just the desire to include it. When selecting active investment managers, position size should also reflect the degree to which you want to be rewarded for being right. If a manager outperforms but your allocation is too small, the portfolio may receive little benefit from that successful decision. In other words, manager selection and position sizing should work together. Conviction in a manager's ability to generate excess return should be paired with an allocation large enough for that excess return to matter at the portfolio level.

In general, keep this in mind:

• High-conviction, high-tracking-error ideas often need only modest allocations.
• Diversified active stock strategies typically require larger allocations.
• Core bond positions may need substantial weights to influence portfolio outcomes.
• If a position cannot realistically affect portfolio behavior, reconsider whether it belongs in the portfolio.

The most important position-sizing question is "At this weight, can it actually make a difference?" not "Do I like this investment?"

Bottom line

Effective diversification isn't determined by how many holdings a portfolio contains. It comes from owning investments that make distinct contributions to portfolio risk and return. Before adding a new position, investors should ask not only whether they want exposure to the investment, but whether the allocation is large enough to achieve its intended purpose.