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There's an old joke that's made its way around financial circles over the years and it's one of my favorites for two reasons: a) there's a little in all of us built into the punch line and b) it highlights one of the single most important, yet least understood profit generators there is.
It goes something like this:
An investment banker walks into a room where his cohorts are in a meeting. "I've got good news and bad news," he announces. "The bad news is, we've just lost $100 million. The good news is, it wasn't ours." An associate raises his hand. "What was the bad news again?"
It's humor, but there's more than a grain of truth to the story. Whether we're talking about brokers, bankers, or even your most trusted financial advisor, you cannot 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's not the most exciting part of investing. It's certainly one of the least understood aspects of making money. But there's zero doubt in my mind it is the most important.
Position Sizing stands out above all others as the most powerful, and not just for cutting risk either, but for boosting your profits, too.
Consider this anecdote from noted trading psychologist Dr. Van Tharp:
"We've 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. And after 50 trades, we've 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 – which shows just how important position sizing really is."
Here's how I recommend you start using it right now…
Position Sizing Is the Single Most Powerful Risk Management Tool of All
If you've never heard the term, don't worry: You're not alone. In 30+ years, I've run across a lot of seasoned professionals who have a hard time explaining exactly what position sizing is, let alone why it can lead to bigger profits.
The concept is deceptively simple – controlling the amount of money you place in each trade can lead to bigger profits and mitigate the risk of a catastrophic loss.
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While there are a lot of things to like about position sizing, there are two elements I find particularly compelling:
- You never have to worry about a large chunk of your capital getting vaporized; and,
- You implement this risk management tool before you invest a single penny, which automatically boosts your probability of profit.
It's one of the single most important concepts any investor can learn… or relearn.
Don't Get Caught by This Beginner's Mistake
Many investors start out by swearing to themselves that they won't risk a penny more than a certain amount on any trade. That there's a line they won't cross, no matter how glittering an opportunity they face or how caught up in the moment they are. The major problem with this is that very few investors see the plan the entire way through.
In theory, they apportion no more than 10% (or whatever the figure they deem appropriate) to the risky stocks that they hope will become home runs. But it's a difficult commitment to stick to at times. Many an investor has allowed himself to make an exception, just for this one stock, and gotten burned.
Other times, an investor might stay true to her commitment to never expose more than 15% of her portfolio to riskier stocks. But she puts 10% of her capital into an exciting company that's nonetheless a flash in the pan, and takes a big hit to her portfolio – despite staying true to her original risk guidelines.
The worst offenders by far though are the investors who bet the ranch on a stock or a single option, even one they've thoroughly researched, and who end up with nothing. And while that's sad to see, many millions of investors hurt themselves with minor-seeming positioning mistakes that their portfolios nonetheless take months or even years to recover from.
What these investors don't understand is the science of managing and controlling risk, eliminating it where possible. And that brings us back to position sizing.
Position sizing is the science 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's a percentage loss or a dollar figure.
Position sizing is different. It's about determining how much of something you can buy for maximum profits, or even if you can afford to buy in the first place.
Three Methods for Sizing Your Positions
First, the simplest method – 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 recommendation. Even if you never think about position sizing again, this is a great place to start.
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 either you've got to 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 even with far smaller sums of money. The disadvantages are that there's no accommodation for different types of investments and small accounts can get overexposed if you're not careful.
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Second, other traders prefer the "percent risk" model. This means they are taking positions and using the overall change in value as a function of the risk they can withstand.
With only three variables, the "percent risk position sizing" formula is clear and concise. Best of all, it serves as a great indicator for the appropriate amount of risk for you to take on… whether you're a seasoned and successful investor, or someone who's just getting started.
Here's the formula:
About the Author
Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He's a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs High Velocity Profits, which aims to get in, target gains, and get out clean, and he's also the founding editor of Straight Line Profits, a service devoted to revealing the "dark side" of Wall Street... In his weekly Total Wealth, Keith has broken down his 30-plus years of success into three parts: Trends, Risk Assessment, and Tactics – meaning the exact techniques for making money. Sign up is free at totalwealthresearch.com.