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Portfolio Position Sizing – Accurately Measuring Your Positions

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Introduction

 

 

 

Buying new shares of stocks can be either a fun or stressful experience – this all boils down to whether or not you know what you are doing. You have conducted a thorough analysis of stock(s) that you are interested in using fundamental and technical analysis and have more than enough capital saved up to buy – the only question that remains is: How much is enough? In this lesson we will be covering another risk management technique, otherwise known as portfolio position sizing, and how it can help you save a significant amount of time and money when purchasing shares of stock.

 

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

 

Position Sizing

 

Position sizing is probably one of the most overlooked elements of risk management – but it’s among the most important.

Position sizing is designed to help an investor determine how many shares of stocks to buy based on the value of the portfolio, the investors risk tolerance, and other factors.

 

 

Ignoring position sizing can be dangerous, and concentrating too much of a portfolio in a single stock is extremely risky because individual stocks can, and sometimes do, go to zero. To help guard a portfolio against this risk, savvy investors may use position sizing when investing in individual stocks.

The goal of position sizing is to find an acceptable risk level in a single stock.

 

 

Determining position sizing can help you answer one of the most fundamental questions in investing, which is: How many shares of a stock should you buy? To answer this, investors need to first figure out the maximum risk
that is acceptable in an individual stock.

Most investors may consider an acceptable maximum risk to be 1% of their portfolio in an individual stock. That
said, conservative investors might use as little as 0.5%, while more aggressive investors are willing to accept as much as 2% risk per stock.

Let’s run through an example of how to calculate a position size. Suppose there is an investor interested in buying a hypothetical stock called XYZ.

First, the investor needs to determine how much of their portfolio they are comfortable investing in this particular stock. Let’s suppose that this investor is OK risking 1% of a $100,000 portfolio, or $1000. This is the maximum amount of risk they find acceptable in an individual stock.

Now that our investor has the maximum risk calculated, they can determine the position size or how many shares to buy.

To determine this, they must consider the stock’s price. Suppose stock XYZ is trading at $30 per share – you would then determine the stop loss and how the difference between the purchase price and stop loss relates to the maximum risk of $1000.

Let’s break this down a little further. Suppose that the $30 stock has strong support at $28.25 – so our investor decides to place their stop just below $28 (we can place the stop at $28.00). The difference between the purchase price and the stop loss is $2, which is the risk per share.

So the investor needs to figure out how many shares to buy. To determine this you need to divide the maximum risk per position of $1000 by the risk per share, which is $2. The result is 500, which is the number of shares that you would buy in this example.

If you buy 500 shares of a $30 stock, place a stop loss at $28 and get stopped out, the maximum you will lose is $1000. The loss is 1% of the $100,000 portfolio and is an acceptable amount of risk for the investor involved.

 

 

But the point of position sizing is to keep losses small in relation to the larger portfolio. The benefit is that it’s much easier to recover from several small losses than a single major one.

Let’s consider an example of a series of small losses to illustrate this point. Suppose our investor invested the entire $100,000 portfolio in six stocks that are all trading at around $30 per share. Using the position sizing formula, you would buy 500 shares and use a $2 stop loss in each stock.

If all six stocks stop out for a loss, the worst case scenario is that you lose $6,000 or 6% of the total portfolio. This is a small loss of the total portfolio and relatively easy to recover from.

Let’s consider a more dangerous alternative. Suppose you invested the entire portfolio, all $100,000, in a single stock – and then disaster strikes.

The stock suddenly drops 20% after the company reports dismal earnings. The result is a gut-wrenching loss of $20k of your entire portfolio.

 

 

These types of sudden and very big losses happen in individual stocks more frequently than you might think – and
using a stop loss won’t always protect you because a stock can gap or jump below a stop loss.

There are many ways to help protect against large losses in individual stocks. Among them, diversifying among different types of individual stocks, and the second is position sizing. Because of this, position sizing is one of the most important elements of risk management.

 

 

So make sure to take the time to determine the position sizes that are right for your portfolio before you enter a trade.

 

Quick Recap

In Review…..

Position Sizing

  • Position sizing is probably one of the most overlooked elements of risk management but it’s among the most important
  • Position sizing is designed to help an investor determine how many shares of stocks to buy based on the value of the portfolio, the investors risk tolerance, and other factors
  • Ignoring position sizing can be dangerous, and concentrating too much of a portfolio in a single stock is extremely risky because individual stocks can, and sometimes do, go to zero. To help guard a portfolio against this risk, savvy investors may use position sizing when investing in individual stocks
  • The goal of position sizing is to find an acceptable risk level in a single stock
  • Determining position sizing can help you answer one of the most fundamental questions in investing, which is: How many shares of a stock should you buy? To answer this, investors need to first figure out the maximum risk that is acceptable in an individual stock
  • Most investors may consider an acceptable maximum risk to be 1% of their portfolio in an individual stock. That said, conservative investors might use as little as 0.5%, while more aggressive investors are willing to accept as much as 2% risk per stock
  • First, the investor needs to determine how much of their portfolio they are comfortable investing in this particular stock. This is the maximum amount of risk they find acceptable in an individual stock
  • Now that our investor has the maximum risk calculated, they can then determine the position size or how many shares to buy. To determine this you need to divide the maximum risk per position by the risk per share
  • There are many ways to help protect against large losses in individual stocks. Among them, diversifying among different types of individual stocks, and the second is position sizing. Because of this, position sizing is one of the most important elements of risk management

 

 

Ok, I know that was a lot to swallow all at once but, this is pretty much everything that you need to know about position sizing. Position sizing is a common technique to help reduce any negative impacts from market downswings and is used as a way to help conserve and diversify your portfolio.

Position sizing is calculated using the quotient of the max risk you are willing to risk in a single position, by the risk per share (the difference between the stock price and your determined stop loss). Refer to the examples above for more information.

Although it may be a good idea to actually memorize position sizing each and every time you decide to purchase shares of stocks (or any asset for that matter), most brokers actually provide you with a position sizing calculator for you – they essentially do all the heavy lifting. So do not feel bad if you did not get the hang of the general concepts of this lesson. It is perfectly fine if you opt to depend on using a position sizing calculator instead – you will get the same results.

But it’s important to remember that this should be an aspect to consider before making any investment decision, as it will help guard you against any unnecessary risks.

I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

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