Over the past couple of months, we’ve covered some pretty heavy topics.
First, I introduced you to the up-and-coming — and often confusing — world of crypto assets. Then we took a deep dive into “portfolio thinking” and saw how one of the world’s greatest investors built the “holy grail” of portfolios.
So, this week I thought we’d lighten things up with a return to basics.
You see, here at TradeSmith, we believe there are a few key “rules” you need to know to be a successful investor.
And unlike a lot of investment advice out there, these rules can be helpful no matter what type of investor you are, which assets you’re investing in, or whatever particular investment or trading approach you’re using.
It’s important for all of us to be focused on lowering our risk and capturing the maximum reward at the height of this bull market.
These three rules are:
- You should have a clearly defined exit strategy for every position you own.
- You should never risk too much of your money in any single position.
- You should spread your risk across a reasonable number of positions.
Now, regular Money Talks readers may recall I covered the first rule back in February. At TradeSmith, our favorite exit strategy is the trailing stop loss, or just “trailing stop” for short. If you missed my explanation of trailing stops, you can catch up here and here.
Today, I want to talk about the second rule. This one pertains to what we call “position sizing.”
Like our other two rules, this one is pretty easy to understand. But don’t let that fool you. It’s super important. In fact, it may be the most important of the three.
That’s because proper position sizing is your first line of defense against what’s known as a “catastrophic loss.”
A catastrophic loss is the kind of loss that wipes out a massive chunk of your savings. It can set your retirement back years or even decades. And it’s almost always the result of betting too much — of going “all in” — on a single stock or investment.
Of course, even the world’s best investors suffer losses. Losses are a natural and unavoidable part of investing.
But if you hope to be successful over the long run, you must keep those losses relatively small.
It’s just simple math. As losses grow larger, the return required to recover those losses grows much faster. For example:
- A loss of 10% requires an 11.1% gain to break even
- A loss of 25% requires a 33.3% gain to break even
- A loss of 50% requires a 100% gain to break even
- A loss of 75% requires a 300% gain to break even
- A loss of 90% requires a 900% gain to break even
As you can see, the numbers really start to get ugly above a 50% loss. So, your priority as an investor should be to avoid those kinds of losses.
Like I said, proper position sizing is one of the best and easiest ways to do so. And it all starts with changing how you think about your investments.
Pause for a moment and just answer this question to yourself first …
“How do I determine how much money to put into a trade?”
And if you’re seasoned, answer that question to yourself relating to when you bought your first stock!
You see, novice investors tend to think about position size in terms of how many shares they own of a particular asset. And they typically don’t put much thought into this decision. Often, they decide based on little more than the share price of the asset and how bullish they’re feeling.
For example, they may buy 100 shares of Stock A, 300 shares of similarly priced Stock B (which they’re really excited about), 10 shares of higher-priced Stock C, 1,000 shares of lower-priced Stock D, and so on.
But a better way to think about position sizing is in terms of risk. In other words, how much of your total portfolio are you risking in each position?
At TradeSmith, we recommend a “risk parity” approach to investing. That’s just a fancy way of saying we like to risk the same amount of money in each position. And we generally recommend limiting that risk to no more than 3% or so of your total portfolio in each position.
For most folks, most of the time, risking somewhere between 1% and 2% is probably ideal. But if you’re new to investing or extremely risk-averse, there’s no reason you can’t initially risk 1% or even less.
Once you’ve decided how much you’re comfortable risking in each position, you can easily calculate the appropriate position size for a particular investment in just four simple steps.
$100,000 x 0.02 = $2,000
Second, you’ll choose a trailing stop loss for this position using the guidelines I laid out in February. (Again, if you missed those essays, you can review them here and here.) You’ll then divide 1 by your trailing-stop percentage. For this example, we’ll assume you’re using a 25% trailing stop:
1 ÷ 0.25 = 4
Next, you’ll multiply the result of the first step by the result of the second step to get the total position size:
$2,000 x 4 = $8,000
And finally, you’ll divide the total position size by the share price of the stock you want to buy:
$8,000 ÷ $10 = 800 shares
So, in this case, you’d buy 800 shares of the stock.
If the stock were to fall and hit its 25% stop loss, you would stand to lose just $2.50 per share. That’s $2,000, or 2% of your total portfolio.
That’s all there is to it.
And the math works the same regardless of portfolio size, risk tolerance, trailing-stop percentage, or share price.
This process is essentially the same one our TradeSmith tools use to create risk-balanced portfolios automatically. The only difference is that our tools also incorporate our proprietary Volatility Quotient (“VQ”) to further tailor position size to each asset’s specific risk profile.
But as I just showed you, you don’t have to be a TradeSmith subscriber to benefit from proper position sizing.
I hope you’ll give it a try today.