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Use position sizing to minimise your investment risk

by , 31 July 2013

By using position sizing to limit the amount of cash you put into each position, you can spread your investment risk. That's why it's advisable to invest 5% of your cash into one position. Read on to find out why this is so important…

Spreading your risk is similar to the idea of a diversified or ‘balanced’ portfolio.

Diversification is where investors buy shares in different sectors of the market.

For an entire portfolio, the idea is that if one part of the economy does poorly, another might do well.

If you’ve balanced your risk carefully by selecting a variety of stocks, your stronger performers will balance your weaker ones.

But of course it’s not fool proof explains Francois Joubert, analyst of the Resource and Scarcity Report

By ‘spreading’ your risk, you spread your cash in multiple stocks, not just a few or one.

This way, if one stock has a bad run and loses value, it shouldn’t have too much of an impact on your portfolio. And a smaller position size helps contain the fallout of a loss.

How smaller position sizes make losses more manageable

To explain, let’s show you a more detailed look…

If you use 5% of your R100,000 capital on a stock, and that stock’s value drops 40%, you’ve lost R2,000.

That doesn’t sound so bad. Okay the value of your shares is now R2,000 lower (they are now worth R3,000), but it’s better than if you had invested 10% of your capital in a trade.

Putting 10% of your R100,000 capital in a stock that loses 40% would cost you R4,000. This is a much larger portion of your total cash.

The larger the position size, the bigger the hit your portfolio will take if things go wrong. And this means you’ll lose more money.

A R2,000 loss over a few months certainly isn’t fun, but watching your portfolio lose many thousands is serious.

Bottom line: Limit each position size to 5% of your investment capital to reduce your risk.

Use position sizing to minimise your investment risk
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