About Risk Based Position Sizing
Size Your Positions Like The Pros Do
How many shares should you buy when you enter a new position? Most investors are creatures of habit and buy the same number of shares each time, usually some nice round number or dollar amount. Others are a bit more sophisticated and invest a certain percentage of their portfolio value. If your portfolio is $100,000 and you add a new position you might invest $10,000 or 10% or maybe you just buy your usual position of 100 shares. If any of these methods sounds familiar, you need to learn more about how to correctly determine how many shares to buy. The pros refer to this process as “position sizing”. The easiest explanation is to give a simple example. Here is how it should be done.
Measure the total value of your portfolio and then decide on a percentage of that portfolio that you are willing to risk losing on the new position. Let’s say that your portfolio is worth $100,000 and you want to keep any possible loss to less than 1%. (If you risk more than 2% on any transaction professional investors would consider you to be a “gunslinger”.) The plan is to buy shares of XYZ at the current price of $25 per share. Now some of you may jump ahead and figure that if your risk is to be limited to 1% you can buy only 40 shares (40 X $25 = $1,000) but that’s wrong!
The correct procedure is to figure out where your exit is going to be if your timing is off and the stock goes down. You need to have this loss point clearly in mind before you make your purchase. Let’s assume that we decide that our exit will be at $21 if the stock ever drops that far. Now we know our risk per share is $4 and we divide our risk limit of $1,000 by $4 and learn that we can buy 250 shares instead of only 40 shares. If the stock goes up we will make much more with 250 shares than we would have with only 40 shares. But the big surprise here is that risk is still limited to $1,000.