The '2% Solution' Can Save Your Portfolio From Disaster

It was a gamble. Not an investment. He swung for the fences but struck out. In fact, he did more than just strike out, he was no longer in the game... owing his broker more than $100,000.
I've told this story before, but it's worth repeating, as it holds valuable lessons.

A trader shorted $18,000 worth of a penny stock, only to see the stock shoot up more than 650% overnight. When the trader checked his account the next morning, not only did he lose his entire account balance of $37,000, but it showed a negative balance of $106,445.56. (My colleague Brad Briggs tells the entire story, here.)

While there's plenty of lessons that one could pluck from this costly mistake, I want to talk about a glaring one: risk management (or lack thereof in this case).

The trader's account balance was $37,000. He shorted $18,000. That's almost 50% of his capital that he put at risk with one trade. That's downright wreckless.

One of the simplest and most effective ways to protect your capital is through risk management. One popular method is the 2% rule, which means you never put more than 2% of your account equity at risk in any single investment.

For example, if you are trading a $50,000 account, you should risk no more than $1,000 on any given trade. The great thing about this rule is that if you stick to it, you would have to make dozens of consecutive losing trades in order to lose all the money in your account. And even for the newest trader, this would be highly unlikely to happen.

This Simple Math Could Save Your Portfolio

Keep in mind that the 2% number is arbitrary; you can adjust it to fit your level of risk tolerance. But it provides investors with a foundation on which they can make their trading decisions. For instance, in Top Stock Advisor, I allocate about 5% for most positions; for more speculative stocks, I cut that down to 2.5%.

As an example, let's say you wanted to buy shares of Apple (Nasdaq: AAPL) and you only wanted to risk $1,000, or 2% of a $50,000 portfolio. Let's say you use a 20% stop-loss (your stop-loss is also arbitrary and can be changed to suit your risk tolerance). You can now figure out how many shares you will buy.

To find this number, divide 100 by your stop-loss -- in this case 20 -- which results in 5. Then take that number and multiply it by the amount you want to risk, $1,000.

Five times $1,000 is $5,000, which means you can buy $5,000 worth of Apple stock... or 22 shares if the stock is trading at $227 per share.

If Apple declines 20%, you'll lose about $1,000 and exit the position.

But let's say that you want to use a smaller stop-loss of, say 15%, on your Apple position. Here's how the math works:

-- 100 divided by 15 equals 6.7,
-- 6.7 times $1,000 equals $6,700,
-- $6,700 divided by the share price, $227, equals roughly 30 shares.

Determining the proper position size before placing a trade will not only dramatically impact your trading results, but it will help put your mind at ease.

You can adjust each position based on the trade's risk. For example, if you were speculating on a small biotech company that's bound to have a lot more volatility, then you could cut your position down to 1% or 2%.

Why This Matters

Most novice investors go into an investment willy-nilly, with no plan in place, and little concern for the risk they are taking on. They don't analyze the downside, only dreaming about the potential riches that this investment could bring them.

So, when the stock goes against them, they panic. Not wanting to take a loss (as that admits they were wrong, and nobody likes to be wrong), they continue to hold the stock as it drifts lower and lower, hoping for the day it gets back to their entry price so they can at least break even.

The simple fact is that, as investors, we will be wrong. We will incur losses. Chances are even good that we'll be wrong quite often. But as investing magnate George Soros once said, "It's not about being right or wrong, rather, it's about how much money you make when you're right and how much you don't lose when you're wrong."

Every time you make an investment, you'll be faced with this challenge of being right or wrong. Don't believe that realizing a loss constitutes failure.

If you gain a firm grasp on risk management, you'll be leaps and bounds ahead of other investors. Plus, you'll sleep better during market drawdowns, knowing that you have a plan in place that doesn't take extraordinary risks with your capital.

Related Articles

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


More Related Articles

Sign up for Smart Investing to get the latest news, strategies and tips to help you invest smarter.