Archive for September, 2012

Position Sizing 101

Friday, September 28th, 2012

Graph from us dollars

 

What if I told you there is one simple tool that is absolutely vital to investing success – but virtually ignored by most investors?

 

Sounds too good to be true, right? But there is such a tool, and it’s both simple and powerful: position sizing.

 

Position sizing involves an investor’s exposure to a given investment in proportion to the rest of the portfolio of holdings. It determines how many shares of a stock or an options contract you buy.

 

Sounds pretty simple, doesn’t it?

 

So why is it so important? And why does the average investor ignore it?

 

Let’s consider an example – and stay with me, because we’re going to do a little math…

 

You’ve paid off all your high interest debts (of course) and you’ve saved up $10,000 to invest in stocks.  You’re eager to get started.

 

Keep in mind that good position sizing says that you never risk more than 2 or 3 percent of your portfolio on any single investment.  So, let’s say that you’ve decided that you’re willing to risk 3 percent on a new investment.  Since your investable assets total $10,000 that places your position size at $300.

 

It’s time to decide your exit point on this investment. Picking an exit price is a topic that deserves its own discussion, so we’ll keep it simple and assume that you’re going to use a 25% trailing stop.

 

Let’s say that the stock that you want to buy costs $40 per share… that means your 25% stop will initially be $30 per share, putting your starting risk at $10 per share.  Since the total risk you’re willing to take on this investment is $300, proper position sizing tells you that you should purchase 30 shares.

 

Wow… boring, isn’t it?

 

I mean, how are you ever going to get rich buying just 30 shares at a time?

 

But just wait a minute.

 

Now suppose that this company that you’re going to invest in is working on a cure for cancer, and that if their clinical trials are successful (and your source says they will be) then your investment could easily double – or even triple – overnight.

 

Looks like your relatively small investment could pay off big after all.

 

But that brings us to two more questions.

 

Knowing what you know, can you still hold yourself to buying just 30 shares? And can you honor your exit point if the stock falls below $30?

 

Ah, there’s the rub… To quote the late great John Maynard Keynes:

 

The game of professional investing is intolerably boring and overexacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.

 

In other words, succeeding in investing means resisting the urge to gamble…putting aside the quick thrill for long-term gains.

 

In the long run, success in investing is much more satisfying than the temporary excitement of rolling the dice on a position size that’s just too big for your portfolio.  It only takes a few big mistakes to ruin a portfolio.  Plus, big mistakes are deeply discouraging and are difficult to recover from… both financially and mentally.

 

You don’t have to have the genius of Spock to be successful in the markets, but a Spock-like clarity about the risks your taking is essential.

 

TradeStops provides simple tools that give you the information you need on everything from trailing stops to position sizing. This will help you make informed investment decisions and manage your market risks. It’s time to stop gambling with your money, and to start making smart, appropriate trading decisions with TradeStops.

 

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