Today we will discuss a topic that is probably the most important when thinking about investing. It is also often the most misunderstood. ‘What are we talking about?’, you may ask. Well, it is position sizing and risk management. Remember, no one cares about your money like you do. Whether talking about brokers, bankers, or even your most trusted financial advisor, you cannot fully rely on anyone else to care about your money and keep it safe.
At the end of the day, the only thing standing between your portfolio and catastrophic loss is your own caution and proper risk management. I know it is not the most exciting part of investing. But, there is zero doubt in my mind that it is the most important.
Tools to Cut Risk
One tool that I use is called position sizing. It stands out above all others as the most powerful for cutting risk and boosting your profits. To see what I mean, consider this anecdote from trading psychologist Dr. Van Tharp:
“We have 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. After 50 trades, we have 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 and demonstrates just how important position sizing is.”
‘At the end of the day, the only thing standing between your portfolio and catastrophic loss is your own caution and the proper risk management. I know it is not the most exciting part of investing, but there is zero doubt in my mind that it is the most important.‘
A Powerful Risk Management Tool
Position sizing is the single most powerful risk management tool of all. If you have never heard the term, do not worry because you are not alone. Even many seasoned professionals have a hard time explaining exactly what position sizing is, let alone why it can lead to bigger profits. Yet, the concept is actually quite simple. Controlling the amount of money you place in each trade can lead to greater profits and mitigate risk of catastrophic loss.
While there are a lot of things to like about position sizing, there are two elements that are particularly compelling:
- You never have to worry about a large chunk of your capital getting vaporized.
- You implement this risk management tool before you invest a single penny which automatically boosts your probability of profit.
It is one of the single most important concepts any investor can learn to manage their portfolio.
The Beginner’s Mistake
Do not get caught by this beginner’s mistake. Many investors start out by swearing they will not risk a penny more than a certain amount on any trade. There is a line they will never cross, no matter how appealing of an opportunity they face or how caught up in the moment they are. The major problem with this is that very few investors actually see the plan the entire way through. Many investors have allowed themselves to make an exception, just for this one stock, and gotten burned.
The worst offenders by far are the investors who bet the farm on a stock, even one they have thoroughly researched, and end up with nothing. While that is sad to see, millions of investors hurt themselves with seemingly minor positioning mistakes. These mistakes can cause their portfolios to take months or even years to recover from. What these investors do not understand is the technique of managing and controlling risk, eliminating it where possible. That brings us back to position sizing.
What is Position Sizing?
Position sizing is the technique 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 is a percentage loss or a dollar figure. Position sizing is different. It is about determining how much of something you can buy for maximum profits. It also helps determine if you can afford to buy in the first place.
One of the easiest methods to understand 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 stock trade. Even if you never think about position sizing again, this is a great place to start. Let’s look at a very simple example.
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 you either 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 with smaller sums of money. The disadvantages are that there is no accommodation for different types of investments and small accounts can get overexposed if you are not careful.
Just the Beginning
We have just scratched the surface on the topic of position sizing and risk management. There are literally hundreds of position sizing models you can choose from that accommodate everything from liquidity to personal risk tolerances, currencies, expectancy, and much more. The point is you can make position sizing as complicated as you want or as simple as you need. I prefer the KISS (Keep It Simple Stupid) method. Why? For one simple reason; you never want to play the game if you do not have the cash to back it up.
Understanding position sizing puts you miles ahead of other investors who spend their time wondering what to buy while ignoring the critical question of how much to buy. In today’s environment of zero bound interest rates, investors are relying more on the stock market to bring in needed income. Position sizing and risk management will go a long way in making sure you do not bet the farm on any one stock investment.
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