Tuesday, February 01, 2005

Wal-Mart Purchase Sequal

My last recommendation was to look for entry into Wal-Mart (NYSE: WMT). I stated my case and claimed that a good entry position would be in the $55.50-$55.75 region (look for good volume on the breakout). Today, I will describe the second step of investing...position sizing and risk control.

A lot of individual investors have way too much risk tied up in any one investment. It is probably the leading cause of those who are wiped out playing the investment/trader game. As an investor/trader, you have to realize that you are not always going to be correct. You will invest in a complete loser many times in your life (I'm talking about stocks here ladies). So, you must prepare for that inevitability.

We do not want to go into the world of investing being over confident. Being over confident will only lead to foolish decisions. This confidence was hard wired into our brains many years ago. As hunter-gatherers we required an exuding confidence. We needed to try and try again or our families would go hungry. This was accomplished through two emotions: pride and regret. When you have pride you attribute the outcome to something you did personally. When you experience regret you attribute the outcome to an outside source that you had no control over. This process boosts confidence and motivates us to keep trying.

If you are hunting to feed your family, this confidence is necessary. If you are investing, this confidence can take away a future of stability for your family. The stock market knows we are over confident. It shows us “great” opportunities all of the time. We take the bait; if we are right, we are brilliant and if we are wrong, we blame bad luck. So, if investing requires the opposite of hunting, we must learn to shun pride and accumulate regret.

For those of you who want to delve deeper into the subject of risk management and position sizing, might I suggest one of the books located on my sidebar to the right. "Trade Your Way to Financial Freedom" by Dr. Van K Tharp is an excellent introductory text on the subject. There are also many more advanced texts and reports that you could find pretty easily.

For the others, below will be a brief version. This is something every investor has the capability of understanding and should take the time to do so.

Do you realize that you can lose 100% of an investment and only be down 1%-5% in your entire portfolio? It's true. You can be entirely wrong on an investment. You can do everything the experts tell you not to do. If that one investment goes to $0, your portfolio will not be adversely affected.

For instance, let's say you have a $10,000 portfolio and you are a long-term investor. As a long-term investor, you can afford to lose around 5% on any one investment and be relatively safe. For the shorter term trader, you will want a smaller number like 1% or 2%. 5% of $10,000 is $500. We have figured out that you can lose $500 on any one investment and not completely destroy your portfolio.

We will now assume that we get into our Wal-Mart position at $55.80. How many shares should we purchase to be on the safe side? To figure this out you would take $500 and divide it by $55.80, which would yield an anwer of 8.96. We can't really purchase 8.96 shares, but you get the idea. This past example is only if you want to be extremely careful and feel you could lose the entire investment. It is not highly recommended.

Usually you will have a stop, a pre-determined selling price, in mind before the purchase. I would place a stop (real or mental) under the uptrending line around $48.65. Now, instead of risking $55.80 per share you are risking $7.15 per share. Divide $500 by $7.15 and you come up with 69.93. We'll round that off to 70 shares. You can purchase 70 shares of WMT for your portfolio and if everything goes wrong, your portfolio will not be affected harshly.

I hope this helps out your understanding of portfolio management a little. Like I said above, there is a lot more information on the subject out there. Go look for it!

Best Regards,

The Soothsayer of Omaha


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