How to Appropriately Allocate Your Investments

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How much of your net worth should you allocate to each investment class?

This frequently asked question lacks a definitive answer. Why? Because we all have a different set of life goals and live under different circumstances. There are just too many variables out there (age, income, retirement goals, spending habits, etc.) for there to be one simple answer.

But we can all agree that we should have exposure to several investment classes. This much is certain - it's just up to you to figure out how to split up your own pie.

Without a doubt, options investing should get a healthy slice of that pie.

And brokers can help. Options brokers allow you, the investor, the flexibility to allocate your account by specified dollar amount, specified quantity, percentage of available buying power, etc. It is then your responsibility to figure out what works with your risk tolerance and investment goals.

This brings us to the important and rarely covered topic of position sizing.

Too many investors, especially options investors, have a casual attitude toward the management of their investment portfolios. In the constant race for profits, risk management and money management seem to be secondary. The almighty return, the "we want a lot of return, we do not want any risk, and we need the money by Monday" mentality, seems to override the importance of position sizing.

This is particularly true in the options arena. How many websites have you come across that tout outlandish gains with minimal risk and great consistency? All that I need to say in reference to these is... "think about it!"

My cynicism does not mean that the typical options investor can't beat the market by a decent percentage annually.

It just means that "shooting for the moon" is not sustainable.

The Gallup organization and UBS recently conducted a survey that found 39% of respondents believed stocks would deliver at least a 15% annual return over the next ten years.

This projection just goes to show how wishful thinking consumes a large portion of the investing publics' attitude toward returns. Historically, the notion of such returns is unreasonable.

"Whenever I enter a position, I have a predetermined stop. That is the only way I can sleep. I know where I'm getting out before I get in. The position size on a trade is determined by the stop, and the stop is determined on a technical basis." -- Bruce Kovner

Position sizing is possibly the most important aspect of any options portfolio and trading system. As an investor you must always be aware of risk management (how much you are comfortable losing per trade) and money management (the size of the position per trade).

So, as far as "how much should you allocate to each strategy", trade, etc., the answers are ambiguous. I can only speak to the strategies I use, and the sources that I use to inspire my tested strategies.

One of the latter is Dr. Van.K. Tharp. In his highly recommended book Trade Your Way to Financial Freedom , he discusses in great detail the importance of position sizing.

In his book, Dr. Tharp back-tests and compares the effects of different position sizing methods on investment accounts. His tests were based on a trading account of $1,000,000 using a trading system that 595 trades over 5 ½ years.

Here are some of more notable position-sizing methods he compared and the results:

Baseline Model

  • 100 Shares of stock per trade
  • Performance - 0.58% annually
Fixed-amount Model
  • 100 shares per $100,000 of equity per signal
  • Performance - 5.75% annually
Percent- Risk Model
  • 1% of the account equity per signal
  • Performance - 20.92% annually
His tests produce some interesting results to say the least and highlight the importance of position sizing. As I have mentioned before, each investor has different risk tolerances and goals. Dr. Tharp's results are by no means the "holy-grail" for position-sizing.

Each method has pros and cons under varying market conditions. Ultimately as the investor, you need to create suitable investment objectives that coincide with your risk tolerance.

With that said, go ahead and explore varying ways to use position sizing. Try out different scenarios based on the trades we have placed so far this year. Discover which one fits your investment objectives and stick with it.

Remember, investing is not a sprint. It is a marathon.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

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