This One Tool Made the Difference between Bankruptcy and $13 Million

Keith Fitz-Gerald Feb 13, 2015
19 

There’s an old joke that’s made its way around financial circles over the years. 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. But there’s zero doubt in my mind it is the most important.

That’s why it’s the third part of my Total Wealth Strategy.

And one tool called position sizing stands out above all others as the most powerful, and not just for cutting risk either, but for boosting your profits, too.

To see what I mean, consider this anecdote from 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.

Yet the concept is actually really simple – controlling the amount of money you place in each trade can lead to bigger profits and mitigate the risk of a catastrophic loss.

While there are a lot of things to like about position sizing, there are two elements I find particularly compelling:

  1. You never have to worry about a large chunk of your capital getting vaporized; and,
  2. 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 of 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, 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 % loss or a $ 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.

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:

Dollar Risk Size/(Buy Price – Stop Price)

So for example, let’s say you want to buy a $20 stock with an $18 stop loss, and the maximum amount you’ve resolved to risk is $2,000. The formula suggests you buy 1,000 shares.

This model is great for long-term investors and trend followers, in particular. That’s because it regards the risks associated with each trade equally.

Third, another way to do it is to adjust risk according to volatility.

This gets a little more sophisticated, but here’s the formula:

Position Size = (CE * %PE) / SV

CE is the current portfolio size. %PE is the percentage of portfolio equity that a trader is prepared to risk per trade. SV is volatility over some predetermined range like the preceding 10 trading days, for instance.

If a trader with a $100,000 portfolio is prepared to risk 2% of total equity and the volatility is $1.50 over the past 10 days, the result is 1,333 shares initially. However, as volatility drops, a trader using this model would add to positions. As volatility rises, he would cut back. In other words, you can’t just set it and forget it with this method.

The percent volatility model is fabulous for those who like tight stops because it can provide a flexible balance between opportunity and the risk needed to capture it. It’s also adjustable.

Obviously, we’ve just scratched the surface. There are literally thousands of position sizing models you can choose from that accommodate everything from liquidity to personal risk tolerances, currencies, expectancy, and more.

My point is that you can make position sizing as complicated as you want or as simple as you need.

My preference is for “simple” every time, for one simple reason…you never want to play the game if you don’t have the cash to back it up.

Understanding position sizing puts you miles ahead of other investors who spend their time wondering what to buy while ignoring the critical question of how much.

Until next time,

Keith Fitz-Gerald


19 Responses to This One Tool Made the Difference between Bankruptcy and $13 Million

  1. louis mendelssohn says:

    your investing strategy is sound,professional and proven.

    Many thanks.

    LM.

    • Keith says:

      Thanks for the kind words Louis!

      I will do my best.

      Regards and thanks for being part of the Total Wealth Family, Keith :-)

  2. sandra egeland says:

    I don’t know how to start trading and whom to trust any longer. My husband and I have
    already lost most twice in our lives already. Can you help me?
    Thank you
    Sandra egeland

    • Keith says:

      Hello Sandra.

      I would be honored. The best thing to do is to keep reading Total Wealth. I believe you will find it filled with helpful information. Then, if you’re interested and want to take things up a notch, consider the Money Map Report. It’s a well rounded, conservative approach that I believe may resonate with you just as it does with more than a hundred thousand folks every month.

      As always, though, remember that all investing involves risk and the potential for losses. I know that’s not pleasant to think about given your experience, but it’s a fact of life. The key is to keeping them manageable and small along the way in pursuit of profits.

      Best regards and thank you for placing your trust in me as a member of the Total Wealth Research Family, Keith :-)

  3. William says:

    Keith, I am experienced but not that experienced and the problem that haunts me in stock is an overnight the price blows by your stop or blows just past and than shoots back up. Now although wise to have prime stock and collecting dividends and reinvesting it is time consuming but safe. So it would seem to have stock with strong pockets and let that grow and then devote a potion to the safest way to play options which is always dangerous but there is a way to limit your loss and that is you can never loose more than your own so called 2% or what ever % and you can also go with the direction of the market bull or bear also create spreads as you know to collect upfront etc. as as long as you are prepared to unwind a trade to limit your losses unless you use the markets stops you still don’t have to worry about that overnight lets just say bad market luck. Only being able to loose the cost of the premium and broker fee with unlimited profit if the trade goes to your direction chosen sure seems much safer. But it also seems as though most do not have the desire for options because they are confused , I know I was as I am sure everyone who taught there self was. Now this way you know exactly the most can loose and if you use your % that you suggest, what other way would be safer than knowing your loss potential and really have unlimited profit is there, I would certainly be wanting to learn and try thank you for the article.

    • Keith says:

      Hi William.

      Thanks for sharing and for taking the time to post. Obviously a lot of deep thought went into what you’ve asked.

      To that end, there are a number of important questions in your comments. To give them due consideration, I’d like to tackle them in an upcoming set of columns. That way we can spend the time we need on nuances, like, for example, the issue with traders running your stops. There are definitely ways around that.

      Best regards and thanks for being part of the Total Wealth Family, Keith :-)

  4. Paul says:

    How about taking 1/3 positions in researched companies and instead of stop loss buying 2/3 more after market adjustments? If and only one still likes the underlying security.

    • Keith says:

      Hi Paul.

      That’s a great idea. Traders call this “scaling in” and it’s used as another form of risk management because your initial exposure is kept down and you add to the position over time or as market conditions merit.

      Best regards and thanks for being part of the Total Wealth Family, Keith :-)

  5. Roy F. Schoonover says:

    Congratulations, tool notes about this article for my private trading journal. I would add, for those who are uncertain or unable to calculate volatility, try the “standard deviation” option available on several stock graphing packages – set the moving average value to 10 to match the given example.

    • Keith says:

      Thanks for the kind words Roy and for sharing a super idea with everybody. Both standard deviation and an indicator called Bollinger Bands can provide you with a terrific proxy.

      Best regards and thanks for being part of the Total Wealth Family, Keith :-)

  6. gary says:

    While the 2% solution limits risk it requires 50 positions to be held. That is more positions than the individual investor can keep track of without making it a full time job. I would suggest starting with a maximum of 20 holdings (5% each). As the holdings increase in value sell portions of each holding to limit risk exposure, with the goal of getting most of your original investment back into cash to redeploy into new investments while maintaining a portion of your initial shares as “paid for stocks”. Using this approach, your portfolio will build the number of holdings you own while leaving peace of mind that an increasing number of holdings are “paid for stocks”. I suggest limiting your initial investments to solid large cap stocks with a history of increasing dividends. It takes at least 5-7 bull market years to build this type of portfolio into 50 holdings but you should be holding at least 20 “paid for positions” whose dividend on an original cost basis has gone from 2 – 2.5% to 6%. This approach will keep you invested in the market during the bad times because you don’t want to give up the dividends. Time in the market will give a better return than trying to beat the market.

    • Kenneth Young says:

      Gary, great analysis. I appreciate your input & particular angle on investing. I’d like to speak with you more on this subject. If you’re available, please contact me. (kennyyoung@yahoo.com)
      Thank you

  7. Al says:

    Uh, Keith, in reference to your first example: $20.00 stock price, $2,000.00 investment = 100 shares…not 1,000.

    • William Dahl says:

      Hi Al,

      The formula we used in that example was to divide the dollar risk size (in that example, $2,000) by the stock price ($20.00) minus the stop price (in that case $18.00).

      So the number of stocks to buy in that hypothetical scenario would be ($2,000)/($2.00), which equals 1,000.

      Granted, it could have been clearer if we’d worked out the math explicitly! Thanks for keeping us on our toes, and for being a Total Wealth reader.

      -William Dahl, Associate Editor

  8. Daniel Sevigny says:

    Dollar Risk Size/(Buy Price – Stop Price)

    So for example, let’s say you want to buy a $20 stock with an $18 stop loss, and the maximum amount you’ve resolved to risk is $2,000. The formula suggests you buy 1,000 shares.

    What does this result (1,000 shares) tell us ? In this example, according to the result ( 1,000 shares) , should I buy this stock?
    If the answer is yes, why and how many shares ?

    Thank you.

    • Keith says:

      Excellent question Daniel!

      Ultimately, the answer depends on your risk tolerance. However, in this instance, the formula suggests that 1,000 shares is the maximum allowable purchase given the stated $2,000 risk limit and the $18 stop loss.

      Remember, there are two components here. Position sizing assumes that you’ve already made the decision to buy. So it’s really answering “how much.”

      But you raise an interesting point…perhaps an article walking all the way through an example from how to buy to most effectively position sizing would be in order. I’ll work on it for an upcoming column.

      Best regards and thanks for being part of the Total Wealth Family, Keith :-)

  9. pete says:

    how do you define volatility ? how many standard deviations ?

    • Dave Nelson says:

      I’d like an answer to Pete’s question also. Volatility of what? Total Trading account (cash + daily value of current positions?) Just current positions? Seems to me it would be the former as current positions would vary too much as one buys and sells positions, unless one never sells without having an immediate replacement candidate. And this might also might not work well in a bear market.

  10. Jane says:

    One way, not mentioned here, to buy stocks that you would like to own and at a certain price would be to sell a put on that stock. When a option is sold (in this case a put) the seller receives money. If the stock goes down to the price of the strike sold , the seller is obligated to buy the stock. If the stock doesn’t hit the strike price, one keeps the premium, and doesn’t buy the stock. A good way to build up some cash.

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