“Size matters not … Look at me. Judge me by size, do you?
— Master Yoda, Star Wars
Men try to ignore it, women intuitively know it. Sorry Master Yoda, giggle if you must, but when it comes to investing, size does matter. It seems to be one of the most elusive aspects of investing for both do-it-yourselfers’ and professionals alike. You have a great idea for a trade, but how do you know HOW MUCH to invest in your idea?
There are many ways to approach this dilemma:
The most common approach is to allocate a certain percentage of your account to each investment that you hold. Obviously, this keeps the decision clean and simple. If you have an account value of $100,000 and you would like invest in the next big thing like the recent Facebook IPO (tongue-in-cheek), you would simply purchase 10 percent or $10,000 of Facebook stock. While this strategy can help decide how to enter a trade, how do you know when to exit the trade? When do you jump ship on a losing trade or decide to take profits on a winning trade? Knowing when to exit a trade is arguably the most crucial piece of investing in the stock market. This cannot be answered without knowing the risk and reward you are willing to accept in the investment. This strategy does not take this into consideration leaving the financial guru’s of Fear and Greed (most will call this their “gut feeling”) to make the call for you.
Some simply purchase a nice round number of shares per idea. While this sounds simple, it is not based in any real empirical data or financial history that suggests this is a good idea. If you have an account value of $100,000 and would like to invest in 1000 shares of Facebook, it makes no difference if the cost is $10 per share or $50 per share, and you still have no idea when to exit the trade. This is a recipe for disaster. You have now lost control over how much risk or reward you stand to experience, leaving you with an uncontrolled, high risk account that will be lacking in performance under most circumstances. Again, you will likely turn to your helpful advisors, Fear and Greed for more money losing advice.
Reality check: What separates the men from the boys in investing is keeping the emotions of Fear and Greed as far away from your decision making as possible. And the key to doing this is, you guessed it … size.
Size of what you ask? Dollars at Risk. Decide before you enter into a trade what amount of risk you are willing to take. Let’s take the same $100,000 account and decide that each investment can only risk 1 percent of our account value, or $1,000. Our stock is trading at $50 but has been down to $40 in recent months. We can reasonably assume a risk of $10 a share moving forward. Let’s take the money we agreed to risk, or $1,000 and divide that by the risk per share or $10. The result tells us how many shares we should purchase for this trade. A similar approach can be used to decide when to exit the trade, but managing risk is the first key to success.
Real advice for real people: Understand that the results of your portfolio will largely be affected by the size of risk you take with each individual investment, and in this case bigger is not always better. If you feel the emotions of fear or greed creeping in, consider a consultation with a Certified Financial Planner ™ before making any investment decisions.
RC Arseneau is a Certified Financial Planner and lives with his family in Delaware. Please submit any questions or topic requests to AskRc@mail.com.
The information and opinions in this column are provided only for educational and entertainment purposes. Any reference to a financial product or strategy is not to be considered an endorsement or recommendation. The information is of a general nature only and does not take into account your individual objectives, financial situation or needs. It should not be used, relied upon, or treated as a substitute for specific professional financial, legal or tax advice. Investment Performance may vary due to timing and expenses. Rc recommends that you obtain your own independent professional advice before making any decision in relation to your particular requirements or circumstances.