When you buy a stock how much are you will to risk? This age old question can be answered a variety of ways and we will explore it this morning. Hopefully, it may get you to reevaluate how you allocate money to stocks.
First, what dollar amount are you willing to put at risk in relation to the total value of your portfolio? As an example, if the value of your portfolio is $100,000 and you only own 5stocks in equal dollar amounts, then you are putting $20,000 at risk in each idea or 20%.
So the first thing you should do to answer this question is determine what the overall size of each position is in relation to overall value of your portfolio. As an example, in the Morning Matters Portfolio in Superstock Investor we can have up to 12 positions which are in equal value when they start, 8.25%.
If we only had five stocks that each were 20% of the value, then when one lost 2% in value the overall portfolio would lose 5%. When a position of 8.25% loses 25% in value the cost is 2.0625%.
However, over time the value will either rise or drop. A 100% move would see the value of a position rise from 8.25% to 16.50% if gain were 100%. Clearly. a positive impact on the performance. As positions are sold, then we determine the new value of the portfolio and buy a new position of 8.25%.
Also, all positions could be rebalanced to get back to 8.25% but the commission cost would eat up performance. Moreover, letting your winners run until they are up 50%, 100% or even more enables the overall value of the portfolio to grow.
The second risk question is how much are you willing to lose in a position? My answer to this is the inverse, "How much do you think the position will gain in value?" If you are willing to lose 5% before you sell and your goal of profit is 20%, then that is a reward to risk ratio of 4:1. The reward is 4 times the risk.
I prefer to call this ratio the reward:risk ratio even though many prefer to use the term risk:reward ratio. A good investor is going to always make more money owning stocks than shorting stocks. Remember stocks move higher 67% of the time.
Friday I heard a strategist say that he thought the S&P 500 could rise to 3000 from 2874 which is 126 points or 4.38% and that the downside risk was 10% to 15% if the tariff situation worsened. Hardly a bold call and one that made be wonder if hanging around for the last 4% of a move could actually prove to be a fatal mistake if it never materialized and the 15% drop came after a rise of only 2%.
The reward to risk ratio in the above case is therefore 1:2.5 or 1:375. That is a horrible reward to risk ratio. When I buy stocks for the Morning Matters Portfolio I am looking for a reward to risk ratio of at least 4:1. When I recommend option trades my reward to risk ratio is more like 8:1.
So do yourself a favor the next time you go to buy a stock ask yourself what your reward to risk ratio is? It will help you become a move solid investor.