One of the biggest issues both new and experienced traders face, is determining how much they should risk in each of their trades. Equally as important, is to determine the total risk we should take in our overall portfolio. Once we have these risk parameters set, we can then begin to look at the idea of asset allocation. By managing and controlling our risk, then applying an appropriate asset allocation model, we will be able to take better control of our investment portfolios.
As we begin to invest in the markets, it is usually a good idea to begin with a lower risk approach to our trading. Then, when we have more confidence in our investing, we can gradually increase the amount of risk we are taking.
There are two concepts that we need to consider when placing our money into an investment. First, we need to know how much we are willing to lose on each trade we take. This is called our single trade risk, in other words, how much we would lose if we got stopped out of our trade. As a rule of thumb, you will want to risk only between 1% and 5% of your account in each trade you take. Again, start at the lower range, then move up.
Second, we need to know how much we are willing to lose if all our trades go against us. This is called our portfolio risk, that is, how much we would lose if all of our trades got stopped out at the same time. A rule of thumb for portfolio risk would be to stay inside the 10% to 20% range.
After we have an idea of how much we are risking per trade, we can turn our attention to identifying how we are going to allocate our funds. Simply put, this the amount we are going to place in each of the different asset classes. How much do we put into mutual funds? How much do we put into stocks? How much do we put into bonds?
The answer to that question is that it really depends on what type investor you are, what your objectives are, and how much risk you are willing to tolerate.
Typically, assets are divided into several classes, including:
Stocks – Mutual funds, value, dividend, growth, large-cap, mid-cap, small-cap and foreign.
Bonds – High-yield (junk), Low-yield (investment), government, corporate, short, intermediate and long term.
Cash – CD, savings, and money market.
Generally, investors will allocate their funds to one of these classes of assets as they create their personal portfolio allocation. Depending on their level of aggressiveness, they may allocate more funds to one class than another.
As investors become more experienced, they may decide to move some of their funds into alternative assets such as currencies, commodities, private equity, venture capital and insurance products. While these may be available, they may not be appropriate for every investor’s situation.
Typically, when an investor has more time to allow their investments to work, they will have a higher percentage in more aggressive assets such as individual stock. An investor who has a shorter time horizon for their investments will generally be more weighted towards bonds and cash assets.
Here is an example of what a basic percentage base asset allocation might look like:
Aggressive – 80% Stocks/ 15% Bonds/ 5% Cash
Moderate – 60% Stocks/ 20% Bonds/ 20% Cash
Conservative – 20% Stocks/ 50% Bonds/ 30% Cash
While these are not recommendations for determining your specific allocation model, this does give you an idea for how one might allocate their funds. The general idea is that if you have more funds in stocks, you have enough time for the markets to fluctuate in both a bullish and bearish direction, and still come out in the positive. Because stocks have a higher potential return, while at the same time a higher potential risk, more time is needed so any drawdown can be overcome. The opposite is true for someone who has less investing time; they would want a lower allocation in stocks since their time horizon is shorter, giving them less time for stocks to recover. Those in this type of situation will generally need to have their funds readily available to them, since often these are investors who are beginning to live off their investments during retirement.
In addition to the types of asset classes, we can look to allocate funds within the class we are investing. This could consist of different types of stocks, bonds or cash assets. For example, if we are allocating our funds using an aggressive portfolio and have chosen to be in 80% stocks, we would then determine how much of that 80% would be put into more or less aggressive types of stocks. You may decide that you want to be very aggressive and have stocks that are in industries or sectors that are also highly aggressive. This action translates to a high return because of the higher risk you are taking. Examples of these types of stocks include technology, pharmaceuticals, or energy to name a few.
On the other hand, you may decide that you want more steady growth stocks, value stocks, or stocks that pay a dividend. In this case, you still want to be aggressive by having a high percentage in stocks, but you are also investing in stocks that are likely to be more deliberate in how they move.
As you look at the different sectors as well as the different industries in the market, you will want to make sure that you are not over-weighted in one or another. Even if you are investing in more conservative stocks, if they are all in the same sector or industry, you are increasing your risk as those stocks are likely to move together.
So, as you begin the process of developing your plan for asset allocation and risk management, make sure you define what we have discussed. First, determine the amount of risk you are going to take in each of your trades, then decide how much you are willing to risk in your whole portfolio. Next, you will want to determine if you are aggressive, moderate, or conservative in your portfolio- by examining how much time you have to invest as well as your natural ability to handle risk. From this conclusion, you can determine how much you will invest in the different stocks, bonds, and cash classes. As you do so, make sure you also consider from what sectors and industry groups your stocks are in.
Incorporating all of these factors will help you stay in control of your risk as well as your overall portfolio. In building this control, you will develop the confidence and discipline you need to successfully invest for your future.