Position Sizing Models for Long/Short Portfolios: Conviction vs. Risk Budgeting

Abstract

Position sizing is a key factor of performance as well as risk management in long/short equity portfolios. This work is an analysis of two most common approaches: conviction-based and risk-budgeting models. Conviction based sizing awards portfolio positioning to the degree of confidence or power of investment signals and the goal of maximizing alpha through the additional weighting of high conviction decisions. Risk-budgeting strategies by contrast allot capital proportional to preset risk contributions making sure regulated exposure, diversification and conformity by extent in overall portfolio risk allowances. This paper conducts a comparative analysis that evaluates these two methods by measuring the trade-offs in terms of enhancing returns, managing volatility and mitigation of drawdowns. The empirical example shows that conviction-based models can provide focused alpha when market conditions are good but are volatile on downside, whereas risk-budgeting frameworks can provide systematic deviation control at the cost of possibly smaller upside. The article also examines a more realistic way of linking conviction with risk-budgeting techniques in order to arrive at a balance between performance and risk. Practical considerations, such as the data requirements, calibration of the risk model, cost of transactions and restrictions are also discussed to direct portfolio managers in implementing them. The results provide contributions to the academic literature and suggest practical implications to practitioners interested in ways to maximize long/short strategies by engaging in disciplined and well-informed position sizing.