Position Sizing Helps Prevent Big Losses
Keeping the discipline of putting no more than 5 percent of your portfolio in one particular position helps avoid significant losses in your asset portfolio. This applies to any asset class.
Imagine putting all of your retirement savings into stock issued by the company where you work…and then watching the stock decline due to conditions beyond the company’s control. This imaginary scenario became a reality for a lot of employees during past stock market meltdowns and individual companies’ stocks crashes.
Another investment mistake that pertains to position sizing is price leveraging. Let’s say you purchased 500 shares of a company “Z” at $50/share. Then the stock price falls to $30/share and you decide to buy another 500. Your average cost per share of stock now is $40 and you own 1,000 shares.
In one week the stock “Z” falls further, to $10/share. You decide to take advantage of yet another bargain and buy 1,000 shares more, so your average cost per share becomes $25. It is highly possible that the stock price will continue sliding and you may end up with a disproportionally high amount of bad investment….
I emphasize the importance of having discipline about position sizing and diversification so that you will never end up with disproportionally high amount of bad investments. Greed and emotions are worth enemies when it comes to investment.
Samples of Different Investment Vehicles
Below are a few investment vehicles to consider for your Investing money that are diversified among different asset classes:
- Stock Market: Stocks–common or preferred shares of corporate stocks (I like steady ‘dividend growers’); priced in real time
- Stock Market: Stock Options–learn about selling puts and covered calls, otherwise, stay away from option trading
- Stock Market: Mutual Funds–a basket of different companies’ stocks or bonds; priced daily unlike stocks; often have high management fees
- Stock Market: Exchange Traded Funds (EFTs)–also a basket of stocks, commodities or currencies; do not charge management fees; traded like stocks
- Stock Market: Bonds–government guaranteed or corporate bonds; pay interest to debt holders (make sure you research the grade of the bonds)
- Stock Market: Municipal Bonds–issued by municipalities; many are tax-free and offer a nice interest rate but you must research the solvency of the municipality
- Stock Market: Annuities–variable or fixed annuities; could be a great instrument for a retirement investment but most have high management fees and “small font” riders—pay attention and read carefully!
- Rental Real Estate–only properties with positive cash flow which means rental income is higher than all expenses
- Private Businesses–passive or active ownership interest in private businesses (make sure you have proper legal agreements that protect your rights and address your tax liability)
- Different Currencies Investment– diversifying your cash holdings among different currencies (can use currency ETFs or find banks that allow you to hold money in different currencies)
- Art Collection–make sure you know the value of your art pieces and their potential for appreciation over time
- Precious Metal Coins: gold, silver, platinum–these are “real money” and are both investment and insurance vehicles
These are just examples of various asset allocations to consider. You will do just fine with diversifying among few asset classes. However, make sure that within each of the suggested investment classes you further diversify your holdings. For instance, have different stock positions (do not invest more than 5 percent of your stock market portfolio in one particular stock or bond) or different pieces of rental real estate.
Read more on this subject next week…
To Your Wealth, Health and Happiness,