So, you are looking to add General Electric (NYSE:GE), Wells Fargo (NYSE:WFC), and General Motors (NYSE:GM) to your well diversified portfolio. How many shares should you buy when you enter these positions? I like to use SmartStops risk based position sizing calculator to help me determine my purchase quantity.
What is risk based position sizing you might ask? Like many investors, when I first entered the game I would often purchase a quantity of shares based on some round number, such as 150 shares, that would be roughly equal in value to some predetermined percentage of my total portfolio, say 10%. As my investing evolved, two things changed. I began using stop loss orders to limit and manage my risk, and I wanted to tune my risk exposure equity by equity based on each investments risk/reward opportunity. I found risk based position sizing, a strategy championed by Chuck LeBeau, a good way of achieving this. Simply put, when following a risk based position sizing strategy you first determine what percent of your total portfolio you are willing to risk in this position, and then set your share purchase ceiling accordingly taking into account any stop loss protection strategies being deployed.
The formula for calculating the total number of shares you can purchase while remaining below your risk target is a simple one.
(Total dollar amount you are willing to risk divided by the dollars at risk per share)
(% of portfolio willing to risk X portfolio value) / (Current Stock Price - Stop Loss Price)
Following is an example demonstrating how risk based position sizing works. Let’s assume I have a total portfolio value of $58,000 and I am interesting in purchasing shares of General Electric. And let’s assume that if this investment turns south, I am willing to take a $1,000 loss but no more. That $1,000 represents 1.7% of my total portfolio value. Now let’s assume GE is currently trading at $15.96 per share and I am using a stop loss of $15.45 to protect my investment. If I were not using risk based position sizing, I would be nervous putting more than $5,000 of my capital into this position believing I would be risking too much of my portfolio. However, due to my stop loss strategy, I am only actually risking 51 cents per share purchased. Following risk based position sizing, I know I can purchase up to 1,900 shares, roughly $30,000 dollars worth, and still be under my $1,000 risk limit. While I most likely not purchase such a large quantity, due to other opportunities and desire for diversification, I am comfortable committing significantly more than $5,000 in capital to this position knowing that my total value at risk remains below my $1,000 target.
Disclosure: No Positions