One of the most important yet most overlooked aspects of investing is position sizing. When investing in the stock market, you should always know how much you should be willing to lose before establishing a position in a stock. Known as risk or capital management, controlling how much you are willing to lose on each stock investment goes a long way to increase 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 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:
- To establish a baseline, he simulated the purchase of 100 shares of stock whenever a buy signal was encountered. The baseline delivered $32,567 or 0.58% annualized return.
- The next method invested a fixed amount when a signal was given to buy. Dr. Tharp bought 100 shares per $100,000 in equity. This approach returned $237,457 or 5.75% annualized return.
- The third approach invested 3% of account equity. The return for this approach was $321,121.
- The fourth approach used the percent risk model. All positions were sized with the risk at 1% of the account equity. This method returned $1,840,493 or 20.92% annualized.
- The fifth method was based on the volatility of the stock as measured by the average true range indicator. The more volatile the stock, the fewer shares are traded. This method returned $2,109,266 or 22.93% annualized.
As you can see, 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%. You know 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, while five losing trades in a row, 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 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 position sizing for a new stock buy will pay off. By controlling the downside risk, you give yourself a chance to be able to benefit from your winners. Since it is a straightforward calculation, all investors should use percent position sizing as part of their due diligence when making a stock buying decision. It is well worth the time.
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