Stocks have been known to double in two weeks, but they can also sink back to half that amount in a matter of days. Markets trade both up and down -- a reality you may lose sight of in the midst of a bull market. The truth is, no one wins all the time. Unfortunately, losing sight of this fact can cost you.
Remember, you are investing in the stock market to increase your net worth over time. Before you invest, take the time to revisit the basic rules of investing. The best way to succeed, regardless of market conditions, is to approach investing with a plan of action that is well thought out. This means you need a set of procedures with clear steps to follow -- regardless of what the market does. A good start is to ask yourself the crucial question, "How much capital am I willing to risk?"
IT'S ALL ABOUT DISCIPLINE
There is no universal answer to this question, because risk tolerance varies from individual to individual. (For more on determining your risk tolerance, see "Risk: How Much Is Too Much?" at Working-Money.com.) One strategy I find useful in determining how much capital to risk on a single investment is the 2% rule. Using this rule, I close my position if the losses therein exceed 2% of the total value of my portfolio. This means that the maximum loss I should tolerate in any single trade (if I am using the 2% rule) is equal to 2% of my trading equity. If a 2% limit seems tight to you, consider other percentages -- perhaps something that falls between 3% and 5%. For the sake of simplicity, however, let's stick with 2% for this example.
Once you have decided on an appropriate risk tolerance percentage, how do you apply it to investing? Use your total trading capital to calculate the amount you can lose, rather than the total currently committed to the market. Revisit the calculation on a regular basis, such as weekly or monthly.
The 2% rule will help you preserve your capital and minimize your losses.
The 2% rule doesn't mean that if you have $100,000 in trading capital, you can only allocate $2,000, or 2%, to each position. Rather, it means that you must exit the position if the loss is equal to $2,000 when the position is valued based upon its current closing price.
For example, if your total trading capital is $100,000 and you purchase 1,000 shares of a $20 stock, your loss tolerance is still $2,000 -- 2% of your original trading capital -- not $400, or 2% of your $20,000 investment (1,000 x $20). Given this loss tolerance, if the stock goes below $18 per share, you should sell the position because your $2,000 loss limit has been exceeded.
Realistically, this is a relatively narrow risk tolerance level, but that's because the example used 1,000 shares. If you purchased 500 shares, the $2,000 allowable loss would set the trigger point for exit at $16 -- that is, a loss of $4 a share (or $2,000 per 500 shares). If you consider yourself a long-term investor as opposed to a short-term trader, you may find 2% to be a little tight. Again, you may want to experiment with a higher percentage.
Whichever percentage you use, the purpose of implementing this investing rule is to limit your loss and protect your trading capital. Ultimately, it's all about making sure that you are able to maintain enough investment capital to continue with your investment pursuits, regardless of the outcome of any single investment. Too many investors ignore this point, much to their long-term dismay.
R.M. Sidewitz is chief executive officer and founder of Qi2 Technologies, LLC, an investment management company, and the managing member of Qi2 Partners LP, a domestic hedge fund. For additional information on long-term investing, go to www.longterminvestor.org.
Hudson, Jason . "Risk: How Much Is Too Much?" Working Money, Volume 1: November/December.
Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.
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