When I began my involvement in financial markets many years ago - a concept that I was constantly made aware of is the need to risk only a maximum of X% of your capital on any single investment or trade.
Its a guide that you see being replicated by many different resources
out there, being online media or print. And there are many percentages
used to represent the X% but the most common one you keep seeing again and again is 2%.
As
an investor, I pay a lot of attention to properly managing risk in my
portfolio hence the concept appealed to me very much because
irregardless if you are an investor or a trader, it gives you a very
clear and simple rule on how much risk you can assume with a single
investment or trade. For those who are not aware of this strategy, this
is a simple calculation of how it works :-
Trading capital : RM100,000
Stock A trading at RM1.00. You have decided that you will exit the stock if the price drops below RM0.80.
Hence the position you can take if your rule is only risking 2% of your capital on this trade is :
Total capital risk (2 % of 100k) = RM2000
Total trade risk (RM1.00-RM0.80) = 0.20
Position allowed (2000/0.2) = 10000 units
I
tried out this method with my investments and over a period of 2 years.
I noticed that as a vaccum (ignoring other exit criterias), it worked extremely well to ensure that I didn't get wiped out.
Let's face it, you can only thrive in this game if you are IN the game.
Losing all your capital is a sure way of ending in the loser's section.
But at the same-time it created so much noise because I was cutting losses more rapidly because a stocks price volatility changes all the time. I noticed that I was "forced" to adhere to this rule in a lot of the stocks that I still wanted to be in. I had "no choice" but to exit because this rule said so. Although it saved me many times, it also significantly diminished my possible returns in the market.
So how worthwhile it is to use this strategy?
As much as I talk about its downside, it is still a strategy that I use but IN CONJUCTION with other risk management strategies.
For me, as a stand-alone concept, 2% works well only if your strategy
requires that you to trade more often and it requires massive winners to
be successful. Then you will be able to absorb these loses in larger
volumes while waiting for those few big winners.
Using
this method without understanding what your overall strategy - you
could easily be "dying a slow death". Have an honest look at your
portfolio profit/loss history. See how it is working for you. How many
times has it saved you? How much has it saved you? How many times has it
cost you? How much has it cost you?
I
have had to adapt this concept with risk tolerance levels, valuation,
price volatility and price momentum in recent years. Now it plays only
one part of an exit criteria and I highly suggest to investors out
there, stick to 2% or raise it to a higher percentage, but adjust it to
fit the type of investment, the quality of you investment, how volatile
your stock is as well as how patient you are willing to be.
I don't mind paying X% for being COMPLETELY wrong about my investment - just don't ask me to sell just because it hit 2%.
http://www.laburlah.com/single-post/2017/02/27/Taking-the-right-position-size---The-legend-of-Risking-only-2-of-your-capital-on-any-single-investment-or-trade
