In yesterday’s essay, I introduced you to our unique Risk Management Strategy. We discussed the 1st Leg of the three legged stool system: Asset Allocation – the importance of dividing your investment capital into different asset classes. Today, I will reveal to you the other two legs keeping your investments safe.
2nd Leg: Position Sizing
The second leg of the safety stool is position sizing. This is a simple strategy dressed up in a fancy name. The idea here is to limit risk by deciding you won’t put more than $X or X% of your capital in any single investment.
Whereas asset allocation reduces overall risk, position sizing reduces the risk within those asset classes. You do this by putting a limit on what you can put in any one investment.
For example, if you had $700,000, you might put $100,000 in each of our seven recommended asset classes. That’s asset allocation. Position sizing would determine how much of that $100,000 you invested within those asset classes. You might say that you’ll invest no more than $7,000 in any one deal ($700,000 x 1% = $7,000). So if that one investment of $7,000 went down to zero, your investible net worth ($700,000) would go down by only 1%.
Position sizing is how conservative investors protect themselves from catastrophic losses. Tom and I are strong proponents of position sizing. We recommend you pick a limit and stick to it. Especially if you find yourself wanting to “go big” on some gamble like Tom’s dad did with Lehman Brothers.
And keep this very simple axiom in mind: The smaller you can make the limit, the safer you will be. Currently, my position limit is 1% of my investible net worth. But when you are starting out, it will be hard to set such a small limit. A good rule of thumb for most people is 3-5%.
Okay, we’ve covered two legs of our three-legged strategy. But you don’t need to know much about physics to know that stools cannot stand well on two legs. For maximum safety, we recommend a third strategy. This will further protect you by limiting the amount of money you can lose on any individual investment. I’m talking about having an exit strategy or what I call a “Plan B.”
3rd Leg: Exit Strategies
I’m going to explain the exit strategy by referring to one of the asset classes we identified above: stocks that fit into your Performance Portfolio.
You buy these stocks in order to outperform the stock market. When you buy stocks using our position-sizing strategy, you are protected in that you have limited your potential losses to a percentage of your portfolio (1% for me—3-5% for you, perhaps). But you can further reduce your risk of loss by attaching a “stop loss” to each stock you buy.
A stop-loss price is simply a preset price at which you or your broker will sell the stock if its price drops that low. For example, if you set a 25% stop loss on a $20 stock, you or your broker will sell it if its price drops to $15.
This further reduces the risk you are taking to 25% of your position size. Getting back to our earlier example, if the position limit you set was $7,000, you would never invest more than $7,000 in any one stock. If that stock position’s value dropped to $5,250, you would sell it. You would take a loss of $1,750 and no more. Thus your total loss on that investment wouldn’t be $7,000—or 1% of your investible net worth—but $1,750 or only one quarter of 1%.
As you can see, stop losses keep your losses to a minimum. And you have can control what you’re willing to lose.
Stop losses are very effective. They remove emotion (an investor’s great enemy) from consideration when a stock, a group of stocks, or even the entire stock market is tumbling.
As you can see, when you combine stop-loss limits with position sizing, you reduce risk dramatically. To reiterate, position sizing limits the loss you will take on any one particular investment. Stop losses limit the loss you can take in that particular investment to some predetermined percentage (in our example, 25%).
One more example to make sure you get it:
Let’s say you have investible assets of $1.4 million. And you divide that equally into each of our seven asset allocation models. Your risk in any particular asset class is $200,000 or about 14% of your total investible net worth.
Let’s say again that you decide never to put more than 2% of that $1.4 million ($20,000) in any one investment position. That $20,000 is your position size.
You wake up one day and decide to add Super Stock Co. to your portfolio. You plunk down $20,000. And tell your broker to use a 25% stop loss.
You buy the stock at $10. Suddenly, it goes down to $7.50, setting off your stop-loss limit. You sell it, taking a $5,000 loss (25% of $20,000).
Your entire loss at $5,000 is only one-third of 1% of your investible net worth. Not much to fret about. Don’t you agree?
Now, there is much more to tell you about how to use stop-loss limits. One thing, for example, is setting a “trailing” stop loss.
There is also much more to learn about how to establish exit plans (or Plan Bs) for other asset classes such as options, real estate, and gold. We will explain how to do that when we discuss those asset classes in future essays.
Tom and I believe that the first rule of wealth building is “never lose a lot of money.” The best way to follow that rule is to utilize all three of these strategies every time you invest in anything. Remember, a stool can stand very well on three legs. But fails to stand on one leg or two.
P.S. Want to learn more about The Palm Beach Letter’s Asset Allocation? Click here to learn more.
[Ed Note: Mark Morgan Ford was the creator of Early To Rise. In 2011, Mark retired from ETR and now writes the Palm Beach Letter. His advice, in our opinion, continues to get better and better with every essay, particularly in the controversial ones we have shared today. We encourage you to read everything you can that has been written by Mark.]