The second ‘M’ that you have to master is Money Management. This involves managing your risks such that you never suffer huge financial losses in the event of a losing investment.
Risk & money management is essential because no method can guarantee us a winning outcome every time. No matter how carefully we analyze a company or follow a price trend, the price can suddenly reverse downwards because of news events that are impossible to predict. If you risk too much of your money on an investment that goes bad, a single loss can wipe out ten profitable prior investments.
The key to effective money management is to consistently risk a fixed percentage of your capital on any single trade/investment. This fixed percentage should be a maximum of 1.5% – 3% of your capital.
For example, if your capital is $20,000, you can afford to risk $300 (1.5% x $20,000) on any single investment. So if you want to invest in a stock like Bank of America (BAC), does it mean you can only buy $300 worth of shares? No.
Your risk (the amount you can lose) per investment is determined by where you place your stop-loss. Recall in my earlier article that whenever you make any investment, you always place a stop-loss 5% – 8% below your purchase price. If you buy BAC at $10, then you could place your stop-loss at $9.20.
The worst that can happen is that BAC declines in price and hits the stop-loss price of $9.20. So, your maximum risk per share is $10 – $9.20 = $0.80. Since your maximum risk per investment is $300, how many shares of BAC can you afford to buy?
The answer is $300 ÷ $0.80 = 375 shares
In other words, if your capital is $20,000:
- You can afford to invest in 375 shares of BAC at $10 (stop-loss at $9.20)
- Your position in BAC is $10 x 375 = $3,750
- Your maximum risk = $0.80 loss per share x 375 shares = $300
The Position Sizing Formula
Given that our risk per trade is always fixed as a percentage of our capital, the number of shares we can afford to buy would be determined by where we place our stop-loss.
In any investment, first determine your entry price and your stop-loss price. You can then determine your position size using this formula:
Number of shares = (% Risk per trade x Capital) ÷ $ Risk per share
Assume that you want to make a second investment in Google at $700. You decide to place your stop-loss at 644 (8% below the purchase price). How many GOOG shares can you afford to buy?
- Capital = $20,000
- % Risk per trade = 1.5%
- $ Risk per share = $700 – $644 = $56
- Number of shares = 1.5% x $20,000 ÷ 56 = 5 shares (rounded off)
- GOOG investment = $700 x 5 = $3,500
Given a capital of $20,000 and a risk per investment of 1.5%, each investment will make up a position size of approximately $3,500 – $3,800. This means that you will be able to invest into a maximum of five different stocks concurrently. In doing so, the total risk to your portfolio would be 7.5%.
If you decide to risk the maximum of 3% of your capital on each investment, then each position size would be approximately $7,600 and you would only be able to take on three investments concurrently.
If were to use a leveraged margin account or CFDs, you would of course be able to take on much more positions. However, my suggestion is to never expose your portfolio to a total risk of more than 10% at any one time, even if you use leverage.