Most of the time when we invest directly in the stock market, we worry about target prices and buy below prices.

There’s obviously a good reason for that. Those two numbers dictate how much we can make. What’s more, they’re readily available from our brokers, investment group, and even on facebook.

What’s missing though is something that we almost never consider: how much money to place on a stock.

Again, there’s an obvious reason for that: we invest what we can, when we can. In fact, we might be investing it regularly through cost-averaging. And over the long-term it hardly matters how much.

But of course, not everyone really goes long-term. We say it to ourselves and then something happens and we get shaken by the market. Maybe we sell early or we seriously ponder (maybe even worry) about it. Maybe we banish it to the back of our minds, tell ourselves we’re in it for the long term and ignore it altogether (the Ostrich effect; yet another one of the “irrational” money behaviors).

It actually doesn’t have to be that way. And in fact, it shouldn’t be. That’s where position sizing comes in.

(This is better suited to active investors using technical analysis and trading in the short- to medium-term. It might be applicable to other scenarios but we’ll leave that for later.)

Let’s say we’re an independent investor. How much of our money are we willing to risk? It can be hard to say. If we’re in the stock market, obviously we’ve accepted the fact that we’ll be taking on risk.

But we’re in it to make money, not lose money. So if we had only 10,000 to invest right now, is it really that easy accept the loss of 1,000? That’s “only” 10% but it can still feel like a big deal – especially if we’re just starting out.

The key is to make sure you’re not risking more than what is acceptable. That can vary per person, depending on their risk appetite. In general, risking 1-3% isn’t too bad – as long as there is a much higher probability of gaining, and the probability of losing isn’t too big.

So if we practice position sizing, we risk only 100 to 300 of our capital.

But what does risking 100 – 300 really mean? Basically, if the trade doesn’t go as we anticipated and we encounter our stop-loss point, we should only be losing up to 300.

(Note: Stop-loss point is the price point at which you know it’s not going your way; in technical analysis, it can be when the support is broken.)

That might be a little confusing, so let’s make an example.

Let’s assume stock AAA is trading at Php100 per share right now. Boardlot is 10; so you fork over Php1000 everytime you buy (let’s ignore taxes and fees for now to keep the math simple).

Let’s assume also that it’s currently at a low price; support is at 98 and resistance is at 105, with a good chance to appreciate some more due to good earnings, strong fundamentals, etc. But the market is unpredictable, and it’s currently trading sideways.

After doing fundamental and technical analysis, you decide that it has a slightly better than even chance for the price to climb – 60% vs 40%

If we were to properly size your position, we probably shouldn’t buy more than 5 boardlots (or 5000 worth of the stock). It would probably be a good idea to buy less than that too.

Why? For two reasons…

First, the risk-reward scenario doesn’t look too good even if there’s a little better than even chance it would gain (60% chance of a 5% gain vs a 40% chance of ~3% loss) . Buying nearer to the support of 98 would probably be a better idea. So we should not put a lot of our money on this trade.

But let’s assume it’s the best one out there right now. So we go ahead and invest anyway. Since our range is 1-3% (of our capital), we should probably be conservative and lean towards 1%.

Second, if we place 5000 and the trade doesn’t go our way (say, support at 98 is broken), we would lose only 150 Php or 1.5% of our capital. (A bit more than we would have liked, but we can’t put our stop loss at 98, since that’s the support and it may hit that just to go up again. What we want is a number where we know it’s not going our way – 97.)

Of course, if our capital is much larger (100,000 for example) risking even 1% of that in a single trade doesn’t make much sense. An alternative is to simply have a fixed amount that we can comfortably lose – say 500 Php. After all, 1% of 100000 is already 1000 pesos. It’s still 1%, but it’s a big enough number that we can get uncomfortable with losing it. Especially if we’re pursuing multiple trades (diversifying) and all of them have the potential to lose that much.

The bottom line is that we shouldn’t place ourselves in a position to lose a lot of money if things go wrong. So instead of looking at the reward side and buying a huge amount of shares because of the potential profits, we should concentrate on the risk side and limit our potential losses.

Now, if you’re doing cost-averaging, there’s absolutely no need to do this. Just do your homework and invest in a good company.

If you’re trading based on fundamental analysis, there’s also no point in doing this. Because instead of selling when the price goes down, most likely you would instead be buying – assuming the fundamentals are intact, management is sound, and their competitive advantage remains.

But if you would rather trade using technical analysis, or you feel it’s better to time the market (or you just can’t help yourself), do yourself a favor and limit your risk. Aside from diversification, position sizing is one of the best ways to make sure you don’t hurt yourself financially.

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How To Invest In The Stock Market Series:

• How To Start Investing In The Philippine Stock Market
• How You Should Evaluate Your Stock Broker
• An Overview On Technical Analysis for The Stock Market
• Position Sizing – Or How Not To Lose Your Shirt In The Stock Market
• An Overview Of Fundamental Analysis For The Stock Market
• Elliot Wave – Investor Sentiment, Crowd Psychology, And The Stock Market
• 6 Stock Investing Strategies – Which One Fits You?
• Different Strategies For Bull Markets, Consolidation & Bear Markets
• When Should I Sell My Stock? 
• Learnings from the Stock Market

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