Employ stock position sizing to enhance your profits in the stock market. When investing in the stock market, how much should you be willing to lose before selling your stock? Known as risk or capital management, controlling how much you are willing to lose on each stock investment goes a long way to increasing your overall return.
One method used by many investors is to establish the size of each stock position based on their tolerance for risk. Dr. Van K. Tharp performed an experiment on position sizing in his book Trade Your Way to Financial Freedom. He tested five position-sizing methods where the only variable was how the size of the position was established. Starting with an initial equity of $1,000,000, he simulated 595 trades over a five and a half year period. The results from Van Tharp's stock position sizing study are enlightening:
As you can see, stock position sizing is a proven technique that investors can use to align their share purchases with their risk strategy. Since the percent approach to risk management provides a proven way to improve your return, we will look at this method in a little more detail. The percent risk method gives investors an objective way to determine the size of the risk they should assume for each of their stock or ETF positions.
The objective of the percent risk method is to identify how much you are willing to lose on any stock trade based on the total size of your portfolio. Let’s say you have a $100,000 portfolio. Depending on your tolerance for losses, you may adjust the risk percent from 0.5% to 4%. Not every trade is a winner. If you were to experience five losing trades in a row with only 4% at risk, it would lower the value of your portfolio to $81,537. With 5% at risk with five losing trades, your portfolio would be worth $77,378. At 10%, your portfolio would be worth $59,049. As you can see, it pays to maintain a low risk profile with your investments. After incurring losses like this, you must achieve even higher returns just to break even.
There are two variables to evaluate when establishing how much you are willing to lose. One is the trailing stop and the other is how much money you invest in the stock position. A trailing stop is necessary as it protects you from further losses. Please see our articles on the trailing stop order, trailing stop percent and trailing stop price if you wish to learn more on how to use this technique. Once you establish your trailing stop, you know how much you are willing to lose per share.
For example, after doing your homework, you determine that company ABC is a good buy at $40 with a $4 trailing stop. This means you are willing to lose 10% or $4 per share. The next question is how much money you should risk in this transaction. Using a 4% risk percent, you could buy 1,000 shares investing $40,000 of your total portfolio. This size of a stock position violates the positives of diversification, another way to reduce risk. This is much too large of a position to take for one stock. Risking 1% of your capital or $1,000 indicates you should buy 250 shares of ABC at $40 for a total investment of $10,000. Your risk of loss is $1,000 on an investment of $10,000.
Employing a well thought approach to sizing your position for a new stock buy will pay off. By controlling the down side risk, you give yourself a chance to be able to benefit from your winners. Since is is a straightforward calculation all investors should use percent position sizing part of their due diligence when making a stock buying decision. It is well worth the time.
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