The Money Management Question: How Much Can I Lose?
Disciplined money management makes the difference between success and failure in investing. When considering an investment, too many people ask, "How much can I make?" That's the wrong question. The right question is "How much can I lose?" Let's take the stock market for example (although proper money management applies to all investments). If you buy a stock at, say, $20 a share you typically do so with the hope and expectation that the stock will go up to $30, $40, $50, or more. But what if that doesn't happen? What if the stock goes down to $15 or $10. Since a decline in the stock price wasn't expected, you may start rationalizing. "Well, if I liked it at $20, I must love it at $15." Or, "I'm a long-term buy and hold investor, so I'll just wait until it goes up." Or, "I can't sell now because I would have to take a loss. I'll just wait until I break even and then sell." The problem with that kind of thinking is that the stock may never be profitable. It may never allow you to break even. And you end up selling for a big loss or tying up capital in a losing investment. No matter how much research you do and no matter how refined your analytical abilities may be, the truth of the matter is that some stock positions are going to be losers. So your best bet is to practice sound money management by taking the decision making process out of the question, "How much can I lose?" The 3% Solution Here's how you can answer the question of how much you can lose before you buy a stock. Determine the number of shares you will purchase based on the amount of money you have to invest, the difference between the price at which you purchased the stock and the price you want to exit the position in case it goes against you, and the percentage of your money you want to risk. For example, let's say you have a $25,000 account. Let's also say that you want to buy a $20 stock and that you want to get out if it trades to $18 (10% lower). Make up your mind that you will not risk more than 3% (or less) of your account on any one position. Here's your formula… Number of shares = (3% times the account value) / (entry price - exit price) So if you have a $25,000 account and if you buy a stock with an entry price of $20, and if you want to get out of the position if it trades to $18, then the difference between the entry price and exit price is $2. Therefore, you can buy 375 shares (3% of $25,000 divided by 2). That's it. You now have a powerful money management system that will allow you to know how much you can lose before you invest. It will keep you in the game by keeping you from losing a significant percentage of your capital on any one position. And as long as you can stay in the game, the better chance you have to realize big profits. (C) Larry Holmes
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