Spread your capital, don’t increase your risk by putting too much into one investment

Fsp Invest, 30 Jul. 2013

Tags: capital, spread your capital, portfolio management, risk, shares, position sizing, lower your risk, how to lower your risk with position sizing, position size

Position sizing is an important aspect of portfolio management. But, be careful how you split your pot. If you invest too much in each share, you could be worse off. Read on to find out why…

A general rule of responsible investing and good risk management is that you should never invest more than 5% of your portfolio in any single share.

Say you’ve put aside R100,000 to invest in the stock market.

If you used 5% of your capital you’re able to buy ten different stocks. You’ve still got enough cash left to buy another ten stocks if you want.

However, if you use 10% of your capital for each new share, not only does your position size increase, but it also limits your future investments.

Now 10% might not sound like a large percentage of your portfolio. But in ten trades you’ve used up your entire capital.

You have no extra cash to buy shares, explains Francois Joubert, analyst of the Resource and Scarcity Report.

If you increase the amount you invest per share, your risk increases

And you’ve concentrated all your capital in a few shares. This can dramatically heighten your risk should those shares fall.

Because of this, it makes sense to use smaller position sizes to make sure your capital goes further.

Just to hammer the point home, below is an extreme example of what happens if you have too much of your capital in one or two positions…

It’s unlikely (hopefully) that you’d ever have 50% of your investable funds tied up in just two shares. But look what happens if you do...

By using 50% of your capital for one stock, you’ll use all your cash quickly. In fact, if you use 50% of your capital at the beginning — you can only invest in two positions.

That brings us to the next point. Don’t be fooled into thinking ‘the bigger my position is, the bigger my profit will be’.

Even if you think the position is ultra-safe, you can still lose money in any stock.

And if you have your money in just two stocks and you’re wrong about both of them, you can lose a lot of money quickly.

This brings us to the main crux of position sizing…

The most important reason you never put more than 5% of your cash into one position is so that you can spread your risk.

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