Tuesday, February 15, 2005

A Reader Question...

A reader had this question with regards to my second Microsoft post:

"600 shares will cost you more than $10,000. Are we in a margin account or buying up the $10,000 and stop?

Also, any special thoughts on margin account?"

First of all, no I was not using a margin account for the example. The example was very basic and I stated such. I probably did get caught up in the simplicity of the example, though. Thanks for catching it.

The reason why you could have purchased an entire account of only Microsoft stock is because you were getting in at such a risk adverse spot. The purchase area was sitting right above a trendline. The example still holds up. You would have only been risking $500 of your entire account. This should also show you that getting in at an "intelligent" point can really boost the reward you get for a certain level of risk.

But, getting into more detail, many investors/traders along with doing some sort of previous calculation also have a few more rules regarding risk. One of the other rules that would have saved me from this embrrassing mistake is to only put a certain percentage of your portfolio into one stock. This is better known as diversification. Maybe you only want to put 10% of your portfolio into any one stock. This would mean that you could have a maximum of 10 stocks at any one time.

Let's see the new equation with this rule put into place:

$10,000 Portfolio
$10,000 * 5% = $500 at Risk
$25.32 - $24.50 = $0.82 Risk per Share
$500/$0.82 = 609 = Round Down to 600 shares

Only want to put 10% of your portfolio into any one stock:

$10,000 * 10% = $1,000
$1,000/$25.32 = 39.49 = Round Up to 40 shares

So, your "risk" equation will allow you to purchase 600 shares and your "diversification" equation will allow you to purchase 40 shares. To be safe you could always go with the lower of these two equations. Once again, this example and information is basic and more detailed and complex information can be found.

As far as margin accounts go, I'm all for them if the investor knows what he/she is doing. The only way to know that is from hindsight though. If you lost all of your money, margin was a bad idea. If you grew your capital 5X, it was a great idea. I know this answer doesn't help, but it really is on a person to person basis that this decision is made.

Best Regards,

The Soothsayer of Omaha

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