How much are you willing to invest? l Insightful Investing
Last updated 9/19/2018 at Noon
Recreational marijuana is legal in the states of Washington, Oregon, California, Colorado, Nevada and Alaska.
Maybe that explains the horrible traffic in western Washington - just kidding.
What does this have to do with “Insightful Investing?” Last month I described what I look for when picking stocks.
Yes, I still do this for my clients. I ended my column by saying “once you determine the stock, the next question is, how much should I invest?”
Since marijuana has become legal, I have been fielding questions about buying into this emerging market.
I want to be on record as saying that I don’t own or recommend these stocks. I am using them as examples for my point about “position sizing.” If you want to own individual stocks, no matter the stock, then the question about “how much” is relevant.
One of the major dangers with investing in individual stocks is putting too much money into one stock.
If you have a $100,000 investment account and buy $100,000 of one stock then you have no diversification. If you placed $1,000 into 100 stocks, you would have plenty of diversification but maybe more homework than you would prefer.
This is one reason why mutual funds and exchange-traded funds are so popular. It is also one reason why people have an advisor, like me, to do it for them.
When I do it for people, I first complete a financial plan. I look at the overall financial health and goals of each investor. I ask them questions about their risk tolerance, cash flow, capital needs, the entire spectrum of their financial life.
This all happens before I make even one recommendation. I call this, “observation, evaluation, prescription.” It is a term I have borrowed from my passion as a ski instructor.
Once the process of observation and evaluation is completed, I have a deep understanding of the client’s goals.
Sometime during the conversation the client might say something like, “I work for ACME Anvil Company I would like to own shares of stock in this company.”
Or they will say, “What do you think about marijuana stocks?”
I will normally reply by saying, “Let’s see where it might fit.” I am doing some math in my head and trying to minimize the impact to the portfolio in the event the idea does not work.
The starting point for me is always from a negative point of view. How much money am I willing to risk? When will I give up if I am wrong? I never predict the future. I look at how volatile something has been.
For example, Warren Buffet’s Berkshire Hathaway stock has declined 50 percent on more than one occasion during my professional career. I think that is a good starting point.
Can my clients handle a 50 percent decline in a market correction? Just for your information, from the year 2000 to 2009, Microsoft declined almost 75 percent. It took until 2016 for Microsoft to return to the highs it set in the year 2000. Other tech stocks had much more volatility and some went under altogether.
Let’s therefore break down our idea of position sizing into two categories. Owning things that have more potential of going broke and those that have less potential. Even though they all have that potential, some have less probability than others, as a general rule. Microsoft and marijuana stocks are not the same and should not be treated as such.
Once I make the determination to place it in a low probability or high probability category, I begin to determine where it fits.
I will begin by using an account size of $100,000. The math is easy to calculate.
Let’s say I am willing to risk $2,500 dollars on any one idea. If the stock is a “low probability of going broke” (this a judgment call I make), then I assign a potential loss of 50 percent to the initial investment.
A $2,500 dollar loss is 50 percent of an initial investment of $5,000. A $5,000 dollar investment in a $100,000 amount is 5 percent.
A $2,500 dollar loss in a $100,000 account is a 2.5 percent potential loss, per investment. It is possible therefore to have 20 individual stocks in a portfolio of $100,000, $5,000 times 20 equals $100,000.
If the stock is in the category of “high probability of going broke” and I am willing to risk $2,500 per investment, then the math works this way.
A 100 percent loss of $2,500 is still 2.5 percent of the portfolio. Therefore my initial position size is smaller, $2,500. And the blending of these ideas becomes manageable and quantifiable. In the first case my initial investment is $5,000 per position and in the second case, $2,500. In both cases I have predetermined my risk: $2,500.
The key to this approach is to determine how much you are willing to risk on each investment. It is the one thing you have control over. Obviously this takes some serious consideration and planning.
I buy individual stocks for some people because they like it. I like it too. For me, it makes me feel more connected to my investments and the market. It can be very fun. It can also be very volatile. Plan accordingly.
You never know “how high” things can go. Sorry, I couldn’t help myself.
Jeffrey Moormeier of JG Moormeier Financial is a Mukilteo-based financial advisor affiliated with KMS Financial Services, an SEC registered investment adviser. His column does not represent the opinions of KMS Financial Services, nor is it an official prediction or recommendation of any kind. The opinions expressed in this column are generalizations. For advise catered to your specific financial circumstances, contact Jeff directly at firstname.lastname@example.org or 425-931-8898.