If you take one thing away from all of your research into investing, it should be position size. It’s the only part of your investment strategy that is in your control, and it can mean the difference between devastation and glory.
Position size refers to how you much cash you allocate to an investment. It doesn’t matter if it’s cryptocurrencies or municipal bonds. If you don’t practice mindful position sizing, you may end up being financially limited in retirement.
It was eye-opening.
I even met the “Wolf of Wall Street” in person when he tried to buy the firm.
What I learned above all else was how investors fall in love with stocks and the stories that accompany them.
I’ve watched them lose their hard-earned cash thanks to emotional investing.
Brokers were no different.
They fell in love too – and if they bought the story, it was a heck of a lot easier to make a bigger commission by selling that story to you!
There is nothing wrong with loving a stock, or even loving a story – but that is where the relationship should end. Love it, but don’t love it so much that you invest too much money in the company.
There are two schools of thought that combat this issue. The first is position sizing, which I’ll discuss today. The other one is concentration, a strategy in which you hold a few positions and invest a ton of money in each of them. I’ll talk about concentration in a future article.
You must position size to limit potential losses to your portfolio in the event of a major crash in an individual stock.
Without a doubt, you have likely experienced a time when one of your positions crashed overnight. Sudden drops used to be the domain of small cap stocks, but now just about every company is subject to insane volatility thanks to program trading.
By program trading, I refer to the fact that computers using algorithms dominate trading today, and they don’t have any emotion when it comes to buying or selling.
The best way to illustrate position sizing is with an example. Let’s assume you have a $100,000 portfolio. How much should you invest in each stock?
If you are a conservative investor, you should invest no more than 4% in any single position. That amounts to $4,000 per position. Additionally, you should use a trailing stop, also known as a stop loss. The Oxford Club recommends setting this at 25% for most positions.
In your $100,000 portfolio, using a 25% stop loss and a 4% position size would theoretically limit your loss to $1,000 if any single position moved against you ($4,000 x 25% = $1,000).
This means that if you lost on a single position, your portfolio would decrease by only $1,000. Across 25 positions ($4,000 x 25 = $100,000), your maximum loss would be $25,000 if all of your positions hit their stops.
When you position size, you are protecting your assets and developing a disciplined approach to investing. No matter how good a stock’s story, you can limit your investment to a size that you can afford.
It may be 4%, or it may be 10%. Either way, it is a decision you need to determine ahead of time. Your portfolio will thank you!
Next week, I will cover position sizing when trading options.
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Source: Wealthy Retirement