It determines the amount of money you will invest. It directly impacts how much you can gain and how much you can lose. And you are in FULL control.
Sadly, many traders and investors spend almost no time on the one thing they completely control! Seriously, have you ever asked yourself: "How much money do I want to spend on stock XYZ?"
If so, you've already guaranteed your investment will be high risk!
Why? Because in this question, the investment was selected first. And now you're trying to make it "fit" into your portfolio.
The question you need to ask FIRST is:
"How much money do I want to invest?"
The SECOND question is:
"What should I buy with this much money?"
Have you ever heard people say (or have you ever said):
Deciding to spend your money this way doesn't leave a lot of room for your goals, current market conditions, volatility, the price of the investment you’re about to purchase, or your decision being wrong. And the less experience you have, the more likely it is that you'll be wrong...often.
You could also go use the "more is better" approach, and spend a huge amount of your money on a single investment or trade. The intent is that investing more money automatically means more profit.
While it is true that you can make more money if you invest more money, putting more money into a trade or investment doesn't guarantee large gains. It only guarantees that you have a lot of money allocated to one investment. And that, my friends, is high risk.
It also enables you to diversify properly. Unfortunately, diversification is not properly understood by a majority of investors.
Diversification is simply an attempt to select investments that do not move up or down in price in the same way at the same time. You use position sizing to make sure that you can buy more than one or two investments.
As referenced earlier, we do not select an investment instrument until AFTER we have determined how much money to invest!
First, you need to figure out your account or portfolio size. You could choose to use your entire balance, or a certain percentage. For more information on sizing your portfolio, click here.
To help illustrate position sizing, we'll use a portfolio size of $100,000.00 as an example.
So ask yourself: how much of your portfolio are you willing to lose when you make a mistake? Not a pleasant question, but an extremely important one.
Lower percentages keep your portfolio safe when several investments fall in value.
Higher percentages increase overall gains when several investments rise in value.
Typically, sophisticated investors keep this percentage at 2% or less per investment. Using this level ensures that one bad choice won't have a large effect on their portfolio.
Let's assume that you are willing to put 5% of your portfolio at risk for any one investment. For our $100,000 account, the maximum allowable loss on any investment is $5,000.
Basically, you need to select the criteria or rule you will use to sell an investment. How much (%) do you have to lose before you decide that enough is enough?
In other words, you are planning for the worst case scenario and mitigating it. So YOU are taking control and selecting how much you are willing to lose if you are wrong.
To this end, entering a "stop" with every trade is a great idea; even more so if you have trouble making exit or sell decisions (everyone does at one time or another).
Two common options are fixed-percentage and fixed dollar stops.
A fixed percentage stop is when you say “I am only willing to lose a maximum of x% if something goes wrong”. Typically, this type of stop is used for smaller portfolio sizes (less than 100k or so).
A fixed dollar stop is when you say “The maximum amount of money I am willing to lose, per trade, is $x. This type of stop is usually used with large account sizes.
There are no hard and fast rules for which type to use. The choice is yours, based on which one you like using. Experiment and make your choice.
Not all trading accounts have the ability to use stops. If this applies to your account, you will need to monitor your investments and stick to your rules.
Returning to our example, we'll assume that the largest loss on any one, particular investment was 20%. In other words, this single investment (NOT the portfolio) would lose 20% before we said enough is enough.
To simplify, we’ll consider your money "at risk" if you plan to invest in anything other than a money market or guaranteed interest account (basically cash or cash equivalents).
Keep in mind that even these "cash" related vehicles have some associated risks, such as losses caused by inflation.
Your maximum position size is how much money you invest per investment. This will be based on how much you are willing to lose (max loss to portfolio) and how much you do lose (biggest loss).
You'll want to calculate the position size that makes these two things equal.
Back to our running example:
We said that the largest amount we were willing to lose is 5%, and the biggest loss we ever had was 20%. So we have the following question:
20% of what number is equal to 5% of our portfolio size?
Or, in mathematical terms:
20% x $???,??? = 5% x $100,000
$???,??? = (5% x $100,000) / 20%
$???,??? = $25,000
So...in this theoretical example, you could have 4 investments in your $100,000 portfolio. This also means that ALL 4 would have to lose 20% (your biggest loss ever) in order for your account value to drop 20%.
There are many considerations when making an investment, in addition to the actual "asset" that you intend on buying.
In order to give you some guidance, please visit our page on the different ways to invest money.
This step is the easiest. To determine the number of shares to purchase, you simply take the position size and divide it by the price (current or where you want to buy the investment instrument).
Lets say you want to buy Google stock as an investment, and it is currently trading at $500 per share.
Now that you've determined how much money you want to invest and the number of shares you're going to purchase, it's time to revisit your financial goals.
How long will am I willing to keep my money in this investment to meet that goal?
Does the position size offer a realistic opportunity to attain the gains I want?
Am I putting too much money into this investment (i.e. HIGH RISK), given my other personal finance goals?