Stock Market for Beginners

“Rule #1: Never lose money. Rule #2: Never forget rule #1.”
- Warren Buffet

How can you prevent losing money? Well, you’d be surprised how few people understand the concept of proper position sizing. It’s actually very simple and will save you a lot of money. Every time you decide “how much” money to put into a trade, you are practicing position sizing.

I was stunned a while ago (this is a true story) when my mom told me that she would always buy a fixed number of shares in a company regardless of price. As a result, she would buy, for example, 20 shares of Krispy Kreme Doughnuts (KKD) at $10/share today and 20 shares of Apple (AAPL) at $100/share tomorrow. That’s a difference of $1800! Both stocks could have equal chances to rise or fall, but a 10% rise in KKD and a 10% fall in AAPL results in a huge loss! Hopefully you can see why this strategy is flawed.

After much research into the subject, I found that the real pros take a risk management approach to position sizing. Here’s the steps you should take before every trade to manage your risk like the pros:

1. Take 1% of the total amount of your portfolio. Let’s say you have $10,000 to invest, then 1% of that is $100. This $100 (*) is the maximum amount you are willing to lose on this single trade.
2. Determine the stop loss point for your stock. This will depend on your risk profile as well as your competency with technical analysis and fundamental analysis (more on this later). For example, if I’m using a pure 10% loss strategy and I purchase Apple (AAPL) at $100, then the stop loss price is $90.
3. Subtract the stop loss price from the purchase price of the stock to find the maximum dollar loss per share. In the example, we get $100 - $90 = $10 (**).
4. Take the maximum loss for portfolio (part 1) and divide by maximum loss per share of stock (part 2) to obtain the number of shares of the stock to purchase. In the example, from (*) and (**), we should purchase $100/$10 = 10 shares of AAPL.

As you can see, this position sizing strategy places equal weights on all of your trades, regardless of the total dollar amount per trade. You will always be risking at most 1% of your total portfolio for each trade. If you have a healthy risk appetite, you can shoot for 2%, but anything higher than that is too much.

Let’s say now that we want to use a 5% stop loss strategy (with the same portfolio balance). If AAPL is still at $100/share, we would be risking $5/share. Therefore, we would purchase $100/$5, or 20 shares of AAPL. In this example, we are spending $2,000 instead of the $1,000 from the previous example on this trade. The amount of risk, however, that we are placing on this trade is the same - namely, 1% of our total portfolio value, or $100.

Always remember Rule #1: Never lose money. By using proper position sizing, you will be diversifying your risk and managing your losses.

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