Before you buy stocks in a company, you must know how many you should buy. Buying stocks always carries some risk, but that does not mean that you need to risk everything. The number of shares you buy in a company is your position. Getting this right will help you achieve optimal returns while minimising your risk. It’s important to remember Warren Buffett’s no. 1 rules of investment.
Warren Buffett’s two rules:
Getting your position size right is quite straightforward. You should never risk more than 0.5% of your capital on any one stock position is the general rule of thumb for investors with more than $200,000 to invest; those with less to invest may risk up to 2% – as their investments pay off, they decrease their risk.
For the purpose of this example, we will not take slippage (money lost when the sale of a stock occurs at a lower price than our price intended) or transaction costs into account. However, these costs mean that actual losses may rise above 0.5% – a reason to keep the risk lower.
You have $100,000 capital for a stock portfolio and want to calculate your position size. Let’s say you want to invest in Facebook. A share costs $75. As a general rule you should never allow a single stock dropping more than -20% since the price level at purchase. If the share price should now fall below $60, you should sell immediately with a stop-loss order to limit your loss and protect your capital. The maximum amount of your capital you want to put at risk is 0.5%.
You will notice that if you buy 33 shares at $75, you are investing 2.475% of your capital in that stock. Since you are within the diversification guideline of not investing more than 5%, you could take that full position.
If you employ a more conservative risk reduction rule and limit the initial maximum stock dropping risk to -10%, you could buy 66 shares ($500 ÷ $7.50) which would represent 4.95% of your stock portfolio and scratching the max. 5% limit.
Investing too much money in too few stocks or too little in too many is one of the main reasons for underperforming portfolios. This is why you must get your position size right.