In a time when market volatility and equity preservation is of utmost importance, determining the correct number of shares to buy, or “position sizing”, is key to maximizing returns and minimizing risk.
The common investor generally doesn’t spend much time thinking about how many shares to buy or how significant of a position to take. Instead, most investors use a common methodology of trading the same number of shares each time, which usually translates to a specific dollar amount. Other, more sophisticated investors, opt to allocate a certain percentage of their portfolio value to a specific position. Following this train of thought, a new position in a portfolio of $100,000 would transcribe either a $10,000, or 10%, investment or a usual position of 50 shares.
Although these methods may work for some, using the volatility of a specific portfolio is likely to be the most effective decision tool. Measuring a portfolio’s overall volatility enables an investor to decide on what percentage of that portfolio he is willing to risk losing on the new position. This methodology is better explained through the following example.
An investor has a portfolio worth $100,000 and would like to minimize any possible losses to less than 1%. The same investor wants to buy shares of Equity A, which has a current bid of $25/share. In this scenario, many investors would logically state that with risk limited to 1%, 40 shares of the equity can be bought (40 x $25 = $1,000), however, this is incorrect.
The correct procedure is to first identify the price point at which the investor would sell Equity A, if it were to spiral into a downturn. For this example, assume that this price point is $21/share. With this in mind, the portfolio’s risk per share is $4 and total risk limit is $1,000 (1% x 100,000 = $1,000), which means that 250 shares of Equity A can be purchased while limiting risk to $1,000.
The upside in this scenario is that if Equity A witnessed appreciation, the total dollar amount added to the investor’s portfolio would be far more significant on 250 shares than on 40 shares, and the total dollar amount at risk remains at $1,000.
The math behind this methodology is relatively simple; however, the difficult part is identifying a price point at which the desired equity could drop in value. www.SmartStops.net, ameliorates this predicament by providing effective, easy-to-implement risk monitoring which identifies price points at which upward trends in stocks and ETFs could potentially come to an end. Rather than guessing at what analytics to use in identifying the true “risk” , SmartStops provides its Position Sizing calculator now on its website so that one can properly allocate to the position based on its individual risk factors. A much needed tool as relying on just modern portfolio theory’s diversification and allocation principles is not enough for our 21st century markets. For more information, see http://smartstops.net/PublicPages/PositionSizingCalculator.aspx .