Every week I chat to my cousin in Cape Town. We usually start off speaking about family politics and end up debating money and investing.
Now, since he's been running a successful transport company in the Western Cape, he's been starting to invest a lot more of his cash.
Usually, he makes relatively solid investment decisions, but this week, he made a classic investment blunder.
He decided to invest 90% of the income he made in 2015, into one listed property company. The other 10% he used as a deposit on a new car.
When I tried to explain the impact of his mistake, he became defensive and highly emotional.
You see, investing all your money into one share is one of the most common investment blunders new investors make. You're blindly putting all your faith in the performance of one company.
This is not a trait of a savvy investor.
I certainly don't want you to make the same mistake my cousin just did...
Why investing like my cousin is a terrible idea!
While I like the company he put his cash into and the car he bought, I certainly don’t like his strategy.
It’s way too risky and downright silly. If something happens to the company and the share price drops, he’d lose most, if not all the money he made in 2015 to this silly investment mistake.
There’s a simple investment strategy that you can follow to prevent this type of mistake destroying your portfolio.
You need to spread your risk to improve your profits
Reduce your overall risk by sticking to asset allocation. This is when you spread your investments across different asset classes, such as stocks, bonds, property, cash and commodities.
Once you’ve decided on the asset classes you’re interested in, you need to look at how you’re going to limit your risk in each of these asset classes.
This is called position sizing and it’s critical to your investment success.
The idea behind position sizing is to limit your risk by not investing too much of your money into one investment, like my cousin did.
How to use position sizing to your portfolio's advantage
Let’s say you have R1 million to invest. Using an asset allocation strategy, you could put R200,000 into five different classes.
Position sizing would determine how you spread that R200,000 in each asset class.
For example, you might decide that you’ll only risk R10,000 in each investment (R1 million x 1%=R10,000) in one asset class. That means if one investment loses all of its value, your investment pot would only fall by 1%.
Pick a risk limit you’re happy with and stick to it. The more you put into one position, the higher the risk you take with one investment.
You also need to limit how much you put into each position.
A good rule of thumb is never to invest more than 4% of your portfolio in one stock. This helps to lower your stock specific risk.
Always have an exit strategy when investing in shares
You must get into the habit of using a trailing stop loss when investing in shares. You need to set an automatic trigger that tells you when it’s time to sell your losing shares.
It also helps to keep your emotions from interfering with your decisions.
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Using a 4% position size with a 25% trailing stop loss, you limit your overall potential loss to 1% of your stock portfolio.
Now that’s a savvy way to invest your money.
Now that you’ve read this, I hope you’re not planning to put a large junk of investment capital into only one or two shares.
It can decimate your portfolio and wipe out all the money you’ve worked so hard to earn.
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Contributing Editor, Real Wealth
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