This Tool Could Mean the Difference Between Bankruptcy and $13 Million When the Market Turns Again
Goldman Sachs is out with a report saying that the economic downturn will be four times worse than the Global Financial Crisis and that the U.S. will see a decline that could be “unprecedented.”
I know that’s hard to imagine, given the rally that’s underway as I type, but you’d be wise to prepare for the possibility.
The only thing standing between your portfolio and catastrophic loss is your own caution and proper risk management.
Even as you chase profits!
Today we’re going to talk about a simple, easy to use tool that can make all the difference in the world when it comes to adding tens of thousands of dollars or even millions of dollars to your bottom line by avoiding portfolio-killing losses.
Risk management is something a lot of folks think they have handled, but very few investors actually do… until it’s too late.
I don’t ever want you to be in that position.
The time to control risk is BEFORE you buy using a simple, easy to implement Total Wealth Tactic called “position sizing.”
If you’ve never heard the term, don’t worry. You’re not alone. In my nearly 40 years in the industry, I’ve run across a lot of seasoned professionals who have a hard time explaining exactly what position sizing is, let alone why it can lead to bigger profits.
Yet the concept is actually really simple – controlling the amount of money you place in each trade can lead to bigger profits and mitigate the risk of a catastrophic loss.
To see what I mean, consider this anecdote from trading psychologist Dr. Van Tharp who has studied position sizing extensively over the years:
“We’ve done many simulated games in which everyone gets the same trades. At the end of the simulation, 100 different people will have 100 different final equities. And after 50 trades, we’ve seen final equities that range from bankrupt to $13 million – yet everyone started with $100,000, and they all got the same trades. Position sizing and individual psychology were the only two factors involved – which shows just how important position sizing really is.”
While there are a lot of things to like about position sizing, there are two elements I find particularly compelling:
- You never have to worry about a large chunk of your capital getting vaporized; and,
- You implement this risk management tool before you invest a single penny which automatically boosts your probability of profit.
It’s one of the single most important concepts any investor can learn… or relearn.
Don’t Get Caught by This Beginner’s Mistake
Many investors start out by swearing to themselves that they won’t risk a penny more than a certain amount on any trade. That there’s a line they won’t cross, no matter how glittering of an opportunity they face or how caught up in the moment they are.
The major problem with this is that very few investors see the plan the entire way through. Many get positively clobbered when the markets sell off hard like they did just this past month.
In theory, those same investors apportion no more than 10% (or whatever the figure they deem appropriate) to the risky stocks that they hope will become home runs.
Admittedly, it’s a difficult commitment to stick to at times. Many an investor has allowed himself to make an exception, just for this one stock, and gotten burned.
Other times, an investor might stay true to her commitment to never expose more than 15% of her portfolio to riskier stocks. But she puts 10% of her capital into an exciting company that’s nonetheless a flash in the pan, and takes a big hit to her portfolio – despite staying true to her original risk guidelines.
The worst offenders by far though are the investors who bet the ranch on a stock, even one they’ve thoroughly researched, and who end up with nothing when the markets have other ideas. And while that’s sad to see, many millions of investors hurt themselves with minor-seeming positioning mistakes that their portfolios nonetheless take months or even years to recover from.
What these investors don’t understand is the science of managing and controlling risk, eliminating it where possible. And that brings us back to position sizing.
Position sizing is the science of cutting risk in your portfolio down to the bone. It answers the question “How big should I make my position for any one trade?”
Many investors think they have this covered with trailing stops that take them out of an investment when some predetermined limit is hit. Usually, it’s a percentage loss or a dollar figure.
Position sizing is different. It’s about determining how much of something you can buy for maximum profits or even if you can afford to buy in the first place.
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Three Methods for Sizing Your Positions
First, the simplest method – and a good rule of thumb – is to make sure you have no more than 2% of your risk capital at stake in any single recommendation. Even if you never think about position sizing again, this is a great place to start.
For an investor with $100,000, that would be buying no more than $2,000 worth of any given stock. If 100 shares cost $5,000, then either you’ve got to buy fewer shares or find another stock at a less expensive price.
The advantages to this model are simplicity, and the fact that you can use it even with far smaller sums of money. The disadvantages are that there’s no accommodation for different types of investments and small accounts can get overexposed if you’re not careful.
Second, other traders prefer the “percent risk” model. This means they are taking positions and using the overall change in value as a function of the risk they can withstand.
With only three variables, the “percent risk position sizing” formula is clear and concise. Best of all, it serves as a great indicator for the appropriate amount of risk for you to take on… whether you’re a seasoned and successful investor, or someone who’s just getting started.
Here’s the formula:
Dollar Risk Size/(Buy Price – Stop Price)
So for example, let’s say you want to buy a $20 stock with an $18 stop loss, and the maximum amount you’ve resolved to risk is $2,000. The formula suggests you buy 1,000 shares.
This model is great for long-term investors and trend followers, in particular. That’s because it regards the risks associated with each trade equally.
Third, another way to do it is to adjust risk according to volatility.
This gets a little more sophisticated, but here’s the formula:
Position Size = (CE * %PE) / SV
CE is the current portfolio size. %PE is the percentage of portfolio equity that a trader is prepared to risk per trade. SV is volatility over some predetermined range like the preceding 10 trading days, for instance.
If a trader with a $100,000 portfolio is prepared to risk 2% of total equity and the volatility is $1.50 over the past 10 days, the result is 1,333 shares initially. However, as volatility drops, a trader using this model would add to positions. As volatility rises, he would cut back. In other words, you can’t just set it and forget it with this method.
The percent volatility model is fabulous for those who like tight stops because it can provide a flexible balance between opportunity and the risk needed to capture it. It’s also adjustable.
Obviously, we’ve just scratched the surface. There are literally thousands of position sizing models you can choose from that accommodate everything from liquidity to personal risk tolerances, currencies, expectancy, and more.
My point is that you can make position sizing as complicated as you want or as simple as you need.
My preference is for “simple” every time, for one simple reason…you never want to play the game if you don’t have the cash to back it up.
Understanding position sizing can put you miles ahead of other investors who spend their time wondering what to buy while ignoring the critical question of how much.
Until next time,