“How can I invest in 10 to 15 stocks if I’m only risking 1 to 2 percent per stock? Wouldn’t I have to buy 50 to 100 stocks if I take such small risks?”
This is a question that has come up often since we first introduced our 10 Steps to Successful Investing system. Let us show you how it’s done.
To start with, let’s look at a list of volatility levels (VQ%) on popular stocks (from May 2015).
We’ve used a similar list as the above in many of our presentations when we’re trying to get across the idea that different stocks have different levels of risk. It’s such a common sense idea that’s nicely illustrated by these lists. We can easily see what our intuition already tells us – some stocks are more volatile than others.
We use these volatility levels as the basis of our Smart Trailing Stops and as the basis for volatility based position sizing.
Let’s take it a step further now and see how we can use this information to create a risk-balanced portfolio.
We’ll start simply and assume that we have $100,000 to invest and that we’re going to risk 1% of our portfolio on each of our investments. To calculate our position sizes using the above volatility levels we simply take $1,000 for each position and divide it by the volatility. Using JNJ as an example, we divide $1,000 by 11.3% to get $8,850. We can invest $8,850 in JNJ and only risk $1,000. If our $8,850 investment in JNJ falls by 11.3% then we would have lost $1,000. Get the idea?
Here’s how that looks (rounded to the nearest dollar) for our list of investments:
Isn’t that amazing? In order to equal risk on both JNJ and TSLA, for example, we can invest $8,850 in JNJ and only $2,315 in TSLA. We personally can’t believe that we ever invested any other way!
As we’ve said before, so much of successful investing boils down to being comfortable and confident in our investments. It’s fun and exciting to invest in volatile high potential stocks like Netflix and Tesla. Adding volatility to a portfolio can even enhance performance. It just has to be done in a balanced way.
If we add up all of the above investments, we get a total of $58,368. By limiting our risk to 1% of our portfolio on these 10 investments we’ve used nearly 60% of our initial $100,000 of capital. What should we do with the remaining 40% of our capital? We could add a few more stocks to our portfolio or we could take a bit more risk in our best opportunities.
Let’s say that we are willing to risk up to 2% of our portfolio on our highest conviction ideas and that we feel most strongly about the potential of JNJ, GLD, XOM, CSX and BIIB. To do so we would just double our position sizes in these 5 stocks.
Here’s how our portfolio looks once we’ve taken our investable capital for each position and figured out how many shares we can buy:
We’ve deployed $92,200 of our $100,000 portfolio across 10 different stocks all balanced for volatility… and the average volatility of our portfolio is a reasonable 16.1%.
We guarantee you that this is a more sophisticated investment portfolio than 9 out of 10 individual investors manage to put together on their own… and all of this can be easily accomplished with TradeStops.
Let’s just sum up what exactly it is that we’ve done here. We:
- Started with a list of 10 investments that we’re interested in.
- Found the volatility quotient, or VQ, on each investment.
- Calculated the initial position size based on a risk of 1% of our portfolio for each position. In this case we assumed a portfolio of $100,000 and risked $1,000 on each investment. We then divided $1,000 by the VQ% to arrive at the approximate position size for each investment.
- Decided to risk 2% on our 5 highest conviction ideas and so doubled the approximate position size.
- Figured out how many shares we could buy of each stock by taking the approximate position size and dividing it by the current price per share.
Pretty simple, huh? Simple, yes, but simplistic? No way.
Let us briefly show you how easy this all is to do in TradeStops.
To calculate the position size, just use the Position Size calculator in the Tools section of TradeStops. Here we’ve said that we’re willing to risk $2,000 on JNJ and use a risk level of VQ%. TradeStops immediately shows us the following result:
TradeStops subscribers can use the VQ Analyzer, also in the Tools section, to easily get insights into portfolio level volatility:
We’re convinced that adjusting position sizes for volatility is the single most important thing that an individual investor must do in order to defy the odds and beat the markets.
Why do we say that?
We’ve come to understand that discipline and risk management are so central to investing to success that these days we think that it’s about the only thing that matters. We’ve long believed that the financial markets are mechanisms for transferring wealth from the many to the few. The important question is, who are the few?
As we see it, the “few” are those investors that think about risk first, not just about reward, and that act in the markets with discipline, conviction and resolve. It doesn’t matter whether you’re a large investor or a small investor. The market pays investors based on how well they manage risk.
Think about it. The financial markets exist because of risk! If there was no risk then there would be no financial markets. Everything would be knowable… and known. Who would need financial markets to hedge their risks?
The markets pay for risk management… and those that manage risk the best, get paid the most. Period.
We sincerely hope that, with the help of TradeStops, you too can become a sophisticated market-risk manager… and a successful investor.
To the growth of your wealth,
TradeSmith Research Team
