i think it can only make sense with discussing stop loss quantum, when viewed from a bigger picture...
the common Stop Loss Exit methods:
a) Long stock $1, stock drops x% => exit
b) Long stock at $1, willing to lose 50cents, stock drops 50% => exit
c) allocate $1 to purchase stock, buy and hold, as long as stock doesn't drop to $0, => no exit (% portfolio theory)
and perhaps there are other variations to the above....
whichever the method stipulated above and the variations to them, it is incomplete until the trader/investor also considers the chances potential rewards... let me elaborate...
take for example, GE shares....in the 2 years between 2005 and 2006, the price gyrated something between $33 - 37 (give and take a few cents)...and we are now in 2007, not knowing where the price will head too, except that i am convinced GE is a great investment and I buy some ... now, do I adopt a), b) or c) stop loss exit plan? the answer really can be a), b) or c).
but i am suggesting that it is not a comprehensive trading approach to choose any of the above conventional methods, without considering the Historical Volatility (HV) of GE price. clearly, GE price exhibited very low HV, something like <7% annualized in 2005 and 2006.
now, does it make sense to adopt :
A) 10% loss exit when GE drops by 10% in price?
B) losses of ~$17 per GE share, which represents 8.7456% of your total investment capital
C) willingness to accept the risk of losing all of ~$35/share of GE (% portfolio theory)
to me, this is how i rationalize the following options above :
A) GE shows me that it has only a ~7% historical volatility...why would i be willing to lose 10% of the share price, when the possibility of making at least 10% is not statistically present? it's foolish to adopt this stop loss option
B) just becos I am willing to lose 8.7456% of my total investment, doesn't mean I need to structure my trade that allows for this possibility, when the investment shows me no reason that it can give me more than $17/share of potential profits. unless, i truly believe hat GE can approach it's "dot.com" high of ~$60/share, i should be aware of my chances of making that potential profit, and risking no more than that amount...
C) again, just becos I allocate 2% of my capital to buy $35/share of GE, doesn't mean I need to allow myself to lose all of that 2%.... % portfolio allocation theory is NOT even a Stop Loss Methodology.... it's for those with no idea how to invest their money except to defray their capital and hope for the best ....
Saturday, February 27, 2010
Hogwash - Portfolio Allocation Theory
Hogwash - Portfolio Allocation Theory
27Feb2010 1725h (+8 GMT)
by Kennynah
quite frankly, i do not agree that a 5% allocation to one trading position is a feasible plan, if one has a small investment capital...
for example, if investment capital is S$10K, 5% allocation is a mere $500. even if this becomes a very successful investment and becomes a multibagger, say 5 times. the overall profit for this position adds $2000 to your account. that's 20% of the investment capital. let's face it, how often do you get a 5x return on your investment. if you are lucky, a rare few times in your entire investment career...
but then why do journalists swear on their ancestral graves that it is wise to allocate no more than 5% of total capital on 1 single position? imo, for 2 primary reasons:
a) they are referring to investment capital amount that is astronomically large; say 100s of millions to billions...think WB, Soros, Pimco category....
b) it's their day job to regurgitate articles to meet their publishing quota
but let's step back and think for a moment.... have a sip of kopi-o, teh-o, pu-er, tia guanyin, diet coke, etc...and ponder....
ponder why we get filled with articles day in and out, people proposing 5% portfolio rule.... why 5% or in essence, why a minuscule fraction of total investment capital ?
you guessed it... it's everything to do with managing risks... by allocating a small % of the total investment capital, one is minimizing risks. and as we know, with little risk, comes little potential profits... and if the total investment capital is small, that small potential reward won't ever make you wealthy...
those with less than $50K investment capital and stick to 5% allocation per trade, imo, are plain lazy. lazy because they know that no matter what, they will never lose more than 5% capital if their investment absolutely belly up...eg, the stock they used 5% capital to buy goes to $0.
let's be honest with ourselves here, if you have the knack of picking stocks that constantly nosedive to the abysmal $0, i think you need to re-evaluate your investment skills...
so, while there is always the chance that your choice of stock can become totally worthless, that chance ought to be tiny. if you believe this, you should not have to worry too much about increasing the allocation amount to more than 5% per asset investment.
instead, you should focus on how much you can afford to lose as your primary determinant on how you trade/invest. in other words, if your risk appetite dictates that you are willing to lose 5% of $50K, then your stop loss exit for any position should be $2500, and NOT allocating a mere $2500 for that position. in fact, you could allocate a substantially larger capital than $2500 and still not risk more than losing $2500, if you possess the knowledge and skills to protect your position beyond losing $2500.
of course, i don't advocate allocating 100% of your capital to one single position. however, minute the chances of this investment going to zero, there's still a chance. and if you invest/trade long enough (and here, i mean decades and numerically very large numbers of trades), it might just occur to you.
in a gist, allocating 5% is not advisable if you want to have a chance of making some real money, neither is it wise to constantly bet the ranch. a balance is needed here. what that balance is, depends on your risk appetite and expected returns.
the biggest advantage in adopting this approach is that this larger capital allocation can reap you a more meaningful potential reward....which is what every trader/investor seeks. remember, you invest/trade not for fun, but to make money....
next time, your friend tells you about his great 5% allocation theory, just smile and talk about the weather....either this or better be his closest buddy; he could be that tycoon you didn't know you knew...
27Feb2010 1725h (+8 GMT)
by Kennynah
quite frankly, i do not agree that a 5% allocation to one trading position is a feasible plan, if one has a small investment capital...
for example, if investment capital is S$10K, 5% allocation is a mere $500. even if this becomes a very successful investment and becomes a multibagger, say 5 times. the overall profit for this position adds $2000 to your account. that's 20% of the investment capital. let's face it, how often do you get a 5x return on your investment. if you are lucky, a rare few times in your entire investment career...
but then why do journalists swear on their ancestral graves that it is wise to allocate no more than 5% of total capital on 1 single position? imo, for 2 primary reasons:
a) they are referring to investment capital amount that is astronomically large; say 100s of millions to billions...think WB, Soros, Pimco category....
b) it's their day job to regurgitate articles to meet their publishing quota
but let's step back and think for a moment.... have a sip of kopi-o, teh-o, pu-er, tia guanyin, diet coke, etc...and ponder....
ponder why we get filled with articles day in and out, people proposing 5% portfolio rule.... why 5% or in essence, why a minuscule fraction of total investment capital ?
you guessed it... it's everything to do with managing risks... by allocating a small % of the total investment capital, one is minimizing risks. and as we know, with little risk, comes little potential profits... and if the total investment capital is small, that small potential reward won't ever make you wealthy...
those with less than $50K investment capital and stick to 5% allocation per trade, imo, are plain lazy. lazy because they know that no matter what, they will never lose more than 5% capital if their investment absolutely belly up...eg, the stock they used 5% capital to buy goes to $0.
let's be honest with ourselves here, if you have the knack of picking stocks that constantly nosedive to the abysmal $0, i think you need to re-evaluate your investment skills...
so, while there is always the chance that your choice of stock can become totally worthless, that chance ought to be tiny. if you believe this, you should not have to worry too much about increasing the allocation amount to more than 5% per asset investment.
instead, you should focus on how much you can afford to lose as your primary determinant on how you trade/invest. in other words, if your risk appetite dictates that you are willing to lose 5% of $50K, then your stop loss exit for any position should be $2500, and NOT allocating a mere $2500 for that position. in fact, you could allocate a substantially larger capital than $2500 and still not risk more than losing $2500, if you possess the knowledge and skills to protect your position beyond losing $2500.
of course, i don't advocate allocating 100% of your capital to one single position. however, minute the chances of this investment going to zero, there's still a chance. and if you invest/trade long enough (and here, i mean decades and numerically very large numbers of trades), it might just occur to you.
in a gist, allocating 5% is not advisable if you want to have a chance of making some real money, neither is it wise to constantly bet the ranch. a balance is needed here. what that balance is, depends on your risk appetite and expected returns.
the biggest advantage in adopting this approach is that this larger capital allocation can reap you a more meaningful potential reward....which is what every trader/investor seeks. remember, you invest/trade not for fun, but to make money....
next time, your friend tells you about his great 5% allocation theory, just smile and talk about the weather....either this or better be his closest buddy; he could be that tycoon you didn't know you knew...
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