Back in September, I wrote an article that outlines the four decision factors that investors can control (yep -- there's only four!). Three of those decisions are on the buy side of the investing cycle. They are:

  • Which stocks to buy
  • What price to pay
  • How large of a position to take

Once you've purchased your stock, there is only one additional factor you can control on the sell side of the equation:

  • To sell or to hold at the current price

Since so much of what we write here at The Motley Fool concerns what companies to buy, and, to a lesser extent, what price to pay, today I thought I would cover the question of how large a position to take. Now, everybody has their own thoughts on this, and in this article, I will share with you the approach that I have adopted in my own investing.

Step One: Think in terms of total portfolio
When I first started investing, I did what many of you probably do. I would come across a stock, decide that I wanted to buy it, and then I'd just invest whatever money I had available in the stock. In other words, if I had $500 in my brokerage account, I'd buy $500 worth of stock. If I happened to have $2,000 in my account, guess how much stock I'd buy -- yep, $2,000 worth. A lot of my friends that are casual investors still do this, and I have to say that it's not the best way to manage your portfolio. 

I'd encourage you to think in terms of total portfolio size. If you have $30,000 in an IRA and another $20,000 in your online brokerage account, then you have $50,000 in total investable assets. If you invest $1,000 in a stock, then that's 2% of your portfolio. If you invest $10,000, that's 20% of your portfolio. 

Step Two: How many stocks
The next step is to determine how many stocks you have the time and the inclination to keep up with. If you're a diehard individual investor, you may invest entirely on your own. Personally, I have anywhere from 15 to 25 stocks in my portfolio at any given time. If you don't have the luxury of spending more than five or ten hours a week on your investments, you probably will need to keep the individual stocks in your portfolio to a more manageable five to ten.

Since I personally don't recommend that the average person invest all of his or her net worth in only five stocks, it's probably a good idea to allocate 50% of your investment assets to a low-cost index fund or your favorite mutual fund, and use the other half of your money as your individual stock portfolio. In the above example, if you've got $50,000 in total assets, you may want to allocate $25,000 to individual stock selection. That way, if you've got 10 stocks in your portfolio, your average position size will be 5% of the total portfolio, which sounds about right.

Step Three: All Stocks are not created equal
Once you've decided on the stock you want to buy, the next step is to determine how much money to put into it. In my own investing, I've come up with the following quick shorthand way of identifying "portion sizes," ranging from smallest to largest.

2.5%  of portfolio      Half position
5.0%  of portfolio      Full position
7.5%  of portfolio      One and a half position
10.0% of portfolio      Double scoop

I use two factors to help me determine how large of a position to take. The first factor is how risky I feel the company is from an operational standpoint, and the second is the price.

I take quarter positions in stocks of companies that I feel are undervalued relative to their growth prospects but that offer higher degrees of risk. For example, one of my favorite small-cap biotech stocks is Ligand Pharmaceuticals (Nasdaq: LGND). I really like this little company, and I feel like it offers a lot of potential for future growth at a reasonable price. But biotech companies that don't have big-selling drugs on the market are inherently very risky, so I limit such investments to 2.5% of the portfolio.

If Ligand fulfills my hopes and triples in value in the next five years, my half position is large enough of an investment to make a big difference in my portfolio returns. On the other hand, if Ligand were to run into trouble and loses half its value, then my portfolio will only lose 1.25%, and if the unthinkable were to happen and Ligand were to go to zero, it wouldn't really hurt me all that much. Essentially, no matter how much I love the company and the stock price, if it isn't profitable and isn't cash flow positive, it falls in this category.

The 5%  position is what I consider standard. I don't get that many great investment ideas in a given year, and I want to make sure that when I get one, I take a meaningful helping. To qualify as a full position, it's got to be a company and an industry that I feel like I understand, I have to have conviction that the stock is undervalued, and it must be a company that is generating strong profits and cash flow. If all of those conditions apply, it's a 5% buy.

The 7.5% buy is when I am really, really convinced that it's a great investment, one of my top three or four investment ideas in a given year. I take the largest position, the double scoop, when I feel like I'm buying a stock of a truly exceptional company at a once-in-a-lifetime price. Typically, I only see one or two of these opportunities a year, maybe less. When I get one, I don't want to waste it by only putting down 2% of my portfolio in it. If necessary, I sell some other stuff to get a double helping of my absolute best ideas. I have on some rare occasions gone above 10% of the portfolio, but now I don't really consider it unless it's such a slam dunk that I don't feel like I can pass it up.

You may be asking, "OK, if you take your 10% double helping and everything goes great and the stock doubles, now you've got 20% of your portfolio in it. Now what?" I've done some thinking about this question, and I'll tackle that in my next article.

Until then, best of luck in your small-cap investing!

At the time of publication, Zeke Ashton owned shares of Ligand Pharmaceuticals. Now that he's mastered stock portion sizes, Zeke is working on food portion sizes. The Motley Fool is investors writing for investors.