Adam O’Dell | Thursday, April 03, 2014 >>
You may have noticed that, here at Dent Research, there’s one critical piece of information missing from our investment recommendations.
That is: How much should you invest in each play?
And readers don’t let us forget it.
They hound us with that question often.
Our standard response is: “We cannot offer individual investment advice.” Then we add: “Always only invest as much as you’re comfortable with.”
In short, we dodge the question.
In our defense, there really is no direct way for us to answer you, because deciding how much of your hard-earned money to invest in the stock market is very personal. It depends on the size of your account, your risk tolerance, and your current situation.
There’s no one-size-fits-all number we can give you.
But that doesn’t mean you can’t find YOUR size-fits-best number. And it’s important that you do. This way, you’ll be able to ensure you risk roughly similar proportions of your total account on each play.
Also, doing so helps you avoid wild swings in your account balance… or at the very least, reduce the volatility attributable to mismatched position sizes.
So here’s some guidance on how to find YOUR number…
Scenario 1 — Boom & Bust recommendations — Buying shares of stock
Subscribers to Boom & Bust receive a dozen or so trade recommendations each year. These are long-term plays that involve buying shares of stock. And there’s very little leverage involved.
In fact, if you buy the shares of stock in your Individual Retirement Account (IRA), you’ll pony up the full purchase price in cash — using no leverage whatsoever.
Now, last year, I recommended subscribers buy Omega Healthcare Investors (OHI) to take advantage of the baby-boomer-driven trend underway in this sector. For this example, let’s say I set the buy-up-to price at $34 per share.
If you had enough money in your investment account, you could have bought say 100 shares for a total investment of $3,400. If your investment account stood at $100,000, this would have been 3.4% of your account.
If you bought the shares in a brokerage account, you could have used margin, where you paid 50% in cash and borrowed 50% from your broker. In that case, you’d have a leverage ratio of 2-to-1, which is mild.
Since little leverage is involved in stock share purchases, it’s generally safe to allocate a relatively larger percentage of your total account to each stock pick. That’s because stock prices don’t often move more than 1% or 2% per day, so the chances of the stock going to $0 is slim.
In Boom & Bust, we usually hit the eject button if a position goes against us by 30%. That means you’d be able to cash out with 70% of your funds intact, even if the position sours on us.
But here’s what you really want to know: While it’s fully your decision regarding how much of your $100,000 account to invest in the stock, a 5% allocation, or $5,000, is within the realm of reasonable. If the stock goes against you, resulting in a 30% loss, you should be able to exit the investment with 70% ($3,500) intact. Your loss of $1,500 amounts to just 1.5% of your total investment portfolio.
This experience, of course, differs greatly with leveraged investment vehicles…
Scenario 2 — Cycle 9 Alert recommendations — Buying stock options
Stock options are leveraged investment vehicles that require a relatively small outlay of cash — usually between $200 and $500 — to control 100 shares of stock.
In the Omega Healthcare example, you could spend just $390 to control 100 shares of stock… instead of investing the full $3,400 required to buy shares.
That leverage gives you the potential to make some powerful gains.
Of course, with that power comes the responsibility to understand the risk involved, since leverage is a double-edged sword.
Unlike shares of stock, the value of option contracts can move by 10%… 20%… or more on any given day. And, there’s a real possibility that the contract will be worth nothing ($0) in a few months’ time.
That’s why it’s important to invest a smaller portion of your total investment account in these plays. Otherwise, you’ll be overleveraged, with an increased risk of “blowing up” your entire account.
So on a $100,000 account, you could invest $1,500 — with the understanding you could lose it all — and still keep your risk limited to 1.5% of your total investment account. That’s the same net effect as the stock purchase, where you allocated 5% and cut your losses on the trade at 30%.
At the end of the day, it’s up to you to do the math to reach that final perfect number. The best way to do that is to follow these three steps…
Step 1: Determine what percentage of your total investment account you’re willing to lose, if the trade goes against you.
This is a completely personal answer. You may be very conservative, willing only to lose half of one percent (0.5%, or 50 basis points). Or you may be comfortable being more aggressive, willing to lose a heftier 2% to 5%.
Naturally, a conservative approach means your account’s gains, and losses, build up more slowly, in smaller increments.
Step 2: Determine the dollar amount you will likely lose, if the trade goes against you.
For stock options, it’s easy: Be safe and assume you could lose the entire debit. So if buying one call option will cost you $300, assume you could lose the full $300.
For shares of stock, determine the percentage you’ll let the price go against you before you hit the eject button.
Then use this simple equation:
Dollar Amount at Risk = Stock Price x Stop Loss Percentage
For example, if the stock price is $30 and you’ve set your stop loss at 30%, here’s what the calculation will look like…
Dollar Amount at Risk = $30/share x 0.30
Dollar Amount at Risk = $9/share
In this case, if you hit your stop loss, you’ll have lost $9 per share.
Step 3: Determine how many shares, or contracts, you can buy.
Once you know your per-unit risk, you can use one more simple equation to determine how many shares of stock, or option contracts, you can buy. The equation looks like this:
Number of contracts or shares = Answer from Step 1/Answer from Step 2
For example, if you were buying stock options, each contract costs $300, and you’re willing to lose up to $1,000 on the position, the calculation will look like this…
Number of call option contracts = (dollar amount you’re willing to risk) / (the cost of the contract)
# of call option contracts = $1,000 / $300
# of call option contracts = 3.33
Therefore, you’d buy three contracts.
And if you wanted to buy stock shares, each share would cost you $30, and you’re willing to lose $9 per share, it would look like this…
Number of shares = (dollar amount you’re willing to risk) / (dollar amount at risk, per share)
The calculation would look like this…
# of shares of stock = $1,000 / $9
# of shares of stock = 111.11
In this case, you’d buy 110 shares of the stock.
So there you have it: A more-helpful answer to the perpetual question, “how much should you invest in each recommendation?”
P.S. As a former broker for an online brokerage firm, I can’t tell you how many times I witnessed self-directed investors make the mistake of NOT doing this math. They’d simply buy 100 shares on every trade… no matter whether it was a $5 per share stock or a $220 per share stock. This resulted in underleveraged positions — where the cheaper investments accounted for just 0.5% of a $100,000 account — and overleveraged positions, where the more expensive investments accounted for a whopping 22% of a $100,000 account!
Here, if you happen to gain 10% on the cheaper investment (netting $50), but lose 10% on the overleveraged position (a loss of $2,200)… you won’t be a happy camper!
Don’t make this mistake yourself! Take the time to do the math…