One Thing You Can Do to Protect Your Portfolio From Big Losses, Part II

I’ve pounded home the idea of asset allocation over the past few days.

The reason is, well, it’s a big deal. It drives 100% of total return levels.

There’s a second way to protect yourself from big losses. Combine it with asset allocation and you’re now well on your way to managing your own portfolio and taking control of your financial future.

This second way is position sizing.

For example, your asset allocation might be something like this…

20% bonds

20% precious metals

40% stocks

10% agriculture and natural resources

10% rental real estate

Position sizing drills down inside those asset classes. The easiest asset class to show an example, is in stocks.

It’s the most important asset class when it comes to position sizing.

The reason is because the average investor wants to hit grand slams. They want the easy path to wealth.

The stock lottery ticket. They want to buy the stock that some financial journalist says could go up 8,000% in six months.

Like I said yesterday, for every stock that does that, thousands go bankrupt. Which means there’s an incredibly high probability he loses all his money.

Then he gets mad as heck and asks the financial newsletter for a refund. Then he moves on to the next bright and shiny ad that says he could become a millionaire by investing in something else.

It’s a vicious circle. A loser’s game.

If you want to buy individual stocks or speculate a little, then you need to understand position sizing.

Let’s look at the asset allocation example above…

It has a 40% allocation to stocks. If you have a $100k divided up as shown above, that means $40k is in stocks.

Let’s say we put $38k into an index fund. Maybe the S&P 500 ETF (SPY). That means 95% of the stock allocation is in a passive fund.

That leaves $2k to buy another stock index fund or individual stocks. If you want to buy individual stocks or want to speculate, you could use that $2k.

If you put it all in a risky stock and lose it, then you’ve only lost 2% of your entire portfolio. If the stock goes up 10x great. But you’re not risking a lot of money for the potential of a huge upside gain.

This is an extreme example to show the power of position sizing. Another example is within the precious metals asset allocation.

Maybe within that 20% allocation (or $20k), 50% or $10k is in gold, 25% or $5k in silver and 25% or $5k in platinum. Again, it’s just something for you to consider.

Everyone’s amount of investable assets is different. Some have $10k to invest. Some have $10m.

Everyone’s risk tolerance is different too. One person may have $100k portfolio and won’t invest more than 2% in any one investment. Which means if the investment went to zero, the investor’s assets would only go down 2%.

A good rule of thumb for most investors in individual stocks is 1-5%. The bottom line is that position sizing is another way to protect yourself from catastrophic losses.

Last week, I asked you to think about asset allocation. Now, it’s time to think about position sizing within those asset classes.