As investors, we spend a lot of time thinking about what we’re going to buy. We study markets, indexes or stocks, and spend hours poring over financial and analyst reports, news and charts. Eventually, we are convinced that stock XYZ has great growth prospects, or is a great value.
Finally, after days or weeks of research, the time comes to buy the stock. You open your online trading account, enter the stock code, or symbol, and the price you want to pay. But there is one more box to fill in – the number of shares. How much of the stock do you want to buy?
If you’re like many investors, most of your time went into choosing the best stock or security to invest in. Then, when it came to deciding the number of shares or contracts to buy, you relied on intuition. After all that research, you determined your position size based on a hunch.
As we’ve chronicled at Truewealth Publishing in recent months, even experienced investors are prone to impulsive, emotional decisions. The field of behavioural finance tells us that modern humans are hardwired to behave in ways that helped our ancestors survive as ancient hunter-gatherers. As a result, we often make decisions based on instinct, or cognitive biases, which can turn out to be investment pitfalls.
(Click here to download our special report on some of the most common cognitive biases, and how even the world’s best investors have fallen victim to them).
Successful investors can control behavioural biases and emotional trading by planning and thinking through their investment strategies. This includes what to buy, when to buy (and sell) and also (importantly) how much to buy.
Being too conservative and buying too few shares can become an emotional problem, especially if the investment becomes a big winner. You may kick yourself for not buying more, but at least you can live with the outcome.
Far more dangerous is buying too many shares. Too large of a position will make an investor more susceptible to something called loss aversion bias.
There is an old saying: “If you can’t stand the heat, get out of the kitchen.” All of us are sensitive to the pain of losing money – too much “heat” and we’re inclined to “get out of the kitchen,” or exit the investment causing our pain. Owning too much of one stock can generate more heat than we can take.
Of course, many great long-term investments go down before they go up. But when we worry too much when the price goes down because we own too much of the stock, we might panic and sell at exactly the wrong time.
Owning fewer shares generates less heat and allows us to tolerate the stock’s price falling – and enjoy the rewards of our correct analysis.
Let’s say you have a S$100,000 account. If you buy S$25,000 of stock XYZ, how will you feel if the stock drops 10 percent, for a paper loss of S$2500? That’s 2.5 percent of your portfolio value. Everyone is different of course, but most of us could handle that size of decline, or “heat.”
However, let’s say you feel very enthusiastic when buying, and you put your entire portfolio into XYZ. Now that 10 percent drop equals 10 percent of your portfolio. That level of heat would make many of us antsy.
We’ll enter the stock symbol on our smartphone app to track it every minute of the day, maybe even setting an alert to notify us if things get worse. A sudden move lower may be more than we can take, so we throw in the towel and dump the shares when prices are falling.
To avoid this, it’s important to decide how much you want to buybefore entering the order. The amount we buy should reflect the amount of heat, or monetary loss, we’re psychologically able to handle.
A simple, effective way to decide position size combines heat sensitivity with a stop-loss strategy. As part of your plan, before entering the trade, decide on a price level for your protective stop-loss. If you’re buying the stock at S$20, you may determine that a fall to S$17 is too much and would be the price to sell.
Now, consider how much of a paper loss (that is, how much it’s gone down on paper, you don’t actually lose money until you sell it) you can handle. With a S$100,000 portfolio, you may feel that a S$2000 loss will make you nervous. So, simply divide S$2000 by that S$3 per share loss you decided you could tolerate, and you get your position size. In this case, that would be 667 shares.
This is one basic formula to help determine your position size, with a table to illustrate:
As an investor, planning the size of your positions and considering how much heat you can withstand could mean the difference between being profitable and getting burned.