Thinking that my earlier post might have scared a few people off the subject of position sizing I’ve put together a very simple spreadsheet that might be useful for investors really concerned about controlling risk without wanting to get into complex mathematical calculations. This spreadsheet uses only discretionary preferences to determine position sizes in a portfolio.
The following figure shows a screenshot of the sheet:
The total portfolio value is first inserted in the salmon colored cell at the top of the sheet – in this example I’ve used our standard $100,000 value.
We next choose our discretionary maximum risk tolerance level based on our own personal aversion to risk – in this example I’ve used 2% (of total portfolio value). This calculates the maximum allowable risk on any individual trade to be $2,000. This will the maximum R value of our trades.
We next select the maximum number of assets that will be used in our portfolio – lets start off by assuming that this will be 4 assets – allowing a maximum of $25,000 to be invested in a single asset (in this example).
Now, we select a level at which a stop loss will be placed to exit the trade – let’s use 8% as a reasonable stop loss level for an equity ETF. This means that if we invest the maximum $25,000 and set an 8% stop, our maximum loss will be $2,000, or the same as our maximum desired loss level based on the 2% portfolio risk restraint.
This is OK so now we can calculate the number of shares to buy – in this example, for a $50 ETF, this would be 500 Shares. QED. The cost per share value is obviously only appropriate to an individual asset – so this number would be changed for each of the remaining (3) assets.
Now, let’s change some of the parameters. We’ll keep our desired portfolio risk level the same at 2% but we’ll change the number of assets that we’ll include in our portfolio:
Let’s assume that we only want to include a maximum of 2 assets in the portfolio. Now, we could invest up to $50,000 in the asset.
However, using an 8% stop loss on this trade would result in a maximum loss of $4,000 – twice the maximum allowable loss based on our 2% portfolio risk level. Therefore, in order to satisfy the portfolio risk restraint we must cut our investment to half the value ($25,000) and keep the ($25,000) balance in cash.
Of course, if the asset in which we were considering to invest was a low volatility bond we might be prepared to set the stop loss level at 4%, rather than 8%, in which case we could now invest the maximum $50,000 in the asset and purchase 1000 shares:
Now, let’s go in the other direction and allow more assets, five, to be included in the portfolio:
Assuming we are placing an 8% stop loss we would purchase 400 shares with a maximum loss on the trade of $1,600 – less than the $2,000 limit based on the 2% portfolio risk limitation. But, of course, we may be buying shares in 4 other assets.
This discipline to control risk through position sizing is simple and has some weaknesses but can be set up to be quite conservative in terms of risk. It does not, of course, control draw-down, but might be a step in the right direction for some investors. The numbers used above are not intended to be recommendations, merely reasonable number to use for purposes of example.