You have done your research on a stock and have determined it’s an attractive investment. Now you are ready to pull the trigger and enter your purchase order. How many shares do you buy?
It’s all a matter of risk control. Over the long-term, risk management contributes much more to a trader’s success than stock selection. Of course stock selection is still very important. But every investor will have both winners and losers. If the outcome of any individual trade is capable of putting a gaping hole in your portfolio, eventually you will fall off the cliff.
Investing while in a state of fear or anxiety leads to emotional decisions, which are typically poor decisions when it comes to stocks. If you are emotional about a trade, you are risking too much. It feels more like gambling. Risking an amount you are comfortable losing is key to staying calm when a stock moves against you and ensuring the survival of your portfolio. It’s your safety net.
So how much can you afford to lose?
The number of shares to purchase should not depend on how much money you want to make. It depends on how much money you can handle losing. The first question is how much of your whole portfolio are you willing to lose? Thinking big picture first allows you to then tailor your individual trade risk based on your own circumstances.
We want to minimize drawdowns as much as possible to make sure you always live to trade another day. Also, it takes a higher return to get back to even. A 50% drawdown would require a 100% gain to bring you back to where you started. Keeping drawdowns to a manageable level protects you from a knock-out blow and leaves you on your feet.
I recommend never risking more than 5% of your portfolio at any single time. That is not the percentage of the portfolio invested in stocks, but the amount at risk. Even in a worst-case scenario, you know that you’ll take a 5% hit. That’s manageable, but still a significant hit. For that reason, I would recommend not having 5% of your portfolio always at risk. That’s the maximum so you should only be fully leveraged when the best opportunities arise. On the other hand, risking only 0-1% is savvy during uncertain times is prudent.
On any given day, 2-3% portfolio risk is much more manageable. That’s the range that I normally fall in. Even if excrement hits the fan, it’s got to do so four consecutive times for me to take a 10% loss. I’ll take those odds. Because I also employ proper trade risk.
A common rule of thumb is that you should never risk more than 2% of your account on a trade. That’s a rule I agree with but in practice I think 2% of your account is way too much risk for a single trade. If you run into a short losing streak of 5 losers in a row, that’s a 10% hit to your portfolio.
This may seem to go right against what I said previously about taking the odds, but the differentiating factor is that my 2-3% portfolio risk is not riding on a single trade. It is comprised of 5-7 positions where each individual trade risk is 0.4% to 0.6%. In order for me to lose 10% of my portfolio, I have to be wrong twenty times in a row. Not five.
I recommend keeping trade risk to 1% or below. If you have a 5% max portfolio risk and 1% max trade risk, you can have a maximum of 5 positions at any given time.
There are two major variables that affect your trade risk:
- Portfolio Amount
- Activity Level
Larger portfolios and higher activity levels lead to less risk per trade. Smaller portfolios and infrequent trading force you to risk more per trade.
Due to commissions and fees, a smaller portfolio requires risking more per trade in order for the game to be winnable. For example, risking $50 per trade in a $5,000 portfolio does not make sense if you have to pay $7 to buy shares and then $7 to sell them. Fortunately, there are commission-free options now such as Robinhood.
Only after you have determined your proper portfolio and trade risk can you calculate the appropriate number of shares to buy. But there is still one more thing to decide: your stop-loss. A stop-loss is the price at which you call it quits on the trade. For example, you may purchase a $10 stock with a stop-loss at $8. If it goes to $8, you sell your position.
The stop-loss should be at a level you don’t expect price to go. If it hits that level, the setup failed and you exit taking the loss you were willing to lose. A stop-loss should be a hard order in the system so it executes automatically. Prices move faster than we do so if it’s not in the system you’re actually risking more than you think. Without that order in the system, price could blow by your $8 “stop-loss” and you’re forced to get out at $7.50. Or even worse, you think you’ll wait until it goes back to $8 to sell, but then it keeps drifting down to $7 and you just increased your loss by 50%.
How Many Shares?
Now you have all the pieces you need to calculate how many shares to buy. Let’s use the example of UCP above assuming a $50,000 portfolio and 1% trade risk.
Number of Shares = ($ Risk Per Trade) / ($ Risk Per Share) = $500 / $2
You can buy 250 shares of UCP.
These risk management principles apply to actively managed portfolios. Retirement accounts are a different animal where you are in it for the long haul. You should not have an eject button on those.
If you are actively managing trades, proper risk control is essential for long-term survival. Imagine if your answer to “how many shares can I buy?” was “as many as I can.” In our UCP example, you would be risking 20% of your portfolio. And that’s assuming you still had the stop-loss. Instead, even with a 20% drop in UCP, you would only take a 1% loss in your account. Position sizing allows you to normalize every trade to fit your risk parameters and limit the volatility of your portfolio, which keeps you in the game.