By Richard Smith, founder, TradeStops
Investing isn’t a one-size-fits-all process. Everyone does it for different reasons.
And your personal goals have a lot to do with how you decide to manage your investments.
You could be looking to earn enough money in the stock market to send your child to college in 10 years. Or you might want to position yourself to make huge gains from a major macro event that you believe is on the horizon.
Maybe you want to protect yourself against economic calamity. Maybe you just want to continue to generate steady income to maintain your current lifestyle.
Your decision-making process and the risk-management strategies you use will be completely different in each of the above scenarios. It’s important to realize that your goals matter. The more you understand your own goals, the more likely you are to achieve them.
And consistently achieving the goals you set will make you a successful investor…
Let’s face it, no stock purchase will ever be risk-free… Taking risks gives investors opportunities to succeed. But different stocks have different levels of risk… And those levels can vary dramatically. So how much risk is the right amount? Again, there is no one-size-fits-all answer. It all depends on your level of risk tolerance.
Risk tolerance is how much exposure to loss you’re comfortable with. It’s how much you can afford to lose in pursuit of a big payoff… and how long you can wait to get paid.
The amount of risk you take can determine how quickly you meet your goals… or whether you meet them at all. If your goals involve a short time frame, playing it safe might not be good enough. But for someone with more modest goals and a couple of decades to work with, the “slow and steady” approach could be smarter.
Start by looking at your investing goals. Can you reach your goals by gradually growing your money over a long period of time? Or do you have lofty goals that require big gains quickly?
Also, remember that different portfolios can handle different levels of risk. A large and carefully diversified portfolio can usually rebound from a loss due to a risky investment, while a smaller portfolio could be destroyed by too many risks or even one big risk.
Consider, for example, two portfolios – one with $25,000 and one with $250,000. Now, let’s look at how different losses could affect them:
Losing $5,000 in the $25,000 portfolio would be devastating. It would cost you one-fifth of your savings. But a $5,000 loss in the $250,000 portfolio would only be 2%.
It’s a simple example. But it’s an important one to keep in mind. And it’s exactly why position sizing is so important to you as an investor.
What is position sizing? It’s putting the right amount of money into your investments relative to your total portfolio size. It’s a challenging concept to grasp, because you have to think about something that most people don’t want to think about: how much you’re willing to risk losing on any single investment.
A good rule of thumb is to risk no more than 4% or 5% of your entire portfolio on any one idea. If you’re risking 4% of a $25,000 portfolio, you’re limiting your potential loss to $1,000 on each investment. If you’re risking 4% of a $250,000 portfolio, then your potential loss would be $10,000 per investment.
Now, let’s see how using a trailing stop will limit your losses. A common strategy to follow is the “25% rule.” It’s simple: Sell if your investment drops 25% from its highs.
Let’s go back to the $25,000 portfolio. If you’re willing to lose $1,000 on each investment and you’re using a 25% trailing stop, how much money should you invest in each position? The answer is $4,000. If your $4,000 investment falls 25%, you will have lost $1,000 – or 4% of your $25,000 portfolio. That’s far less devastating than the earlier example, where a $5,000 loss would cost you 20% of your $25,000 portfolio.
Again… investing isn’t a one-size-fits-all process. An experienced investor with a good track record of success and a large portfolio can afford to take a larger position size. But if you’re just starting out, you likely can’t do that.
Decide what your individual investing goals are. Then figure out the amount of risk you’re willing to take in each investment. Use that amount to determine how much money you should put into each position.
Regardless of your goals, losing too much of your money when you’re just getting started in investing is a surefire way to ruin your financial future.
If you know your risk tolerance, you’ll be able to confidently make the right decisions… and give yourself the tools you need to successfully grow your portfolio.
Dr. Richard Smith
Doc’s note: One of the quickest ways to lose money is betting too much of your capital on one investment, which makes position sizing crucial to your success. Now, calculating your position sizes is simple. Richard’s TradeStops makes it as easy as hitting one button to know how many shares to buy, for any stock, to equalize the risk with your other positions. And he can show you the same thing across your entire portfolio so that you can rebalance to get started. Click here to get access to TradeStops.