The ultimate look at how much to invest in stocks.
Fundamentals 15: This article explores the factors to consider when deciding how much to invest in the stock market. It is linked to portfolio issues like how much you should set aside for stocks and how many stocks to hold.
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| "Don't look for the needle in the haystack. Just buy the haystack!" John Bogle |
How much to invest in stocks? There are several perspectives to this question:
- How much should be allocated to stocks compared to other assets?
- Within the stock portfolio, how much should be allocated to each stock?
- What do you consider when deciding how much to invest in a particular stock?
When you stand back and look at these questions, you can see that there is a common thread. It is about balancing risks and returns.
As there are several levels of investments, you need to ensure that there is consistency when balancing risks and returns at each level. How can you achieve this?
- First, start with a global perspective ie how to spread your savings to various asset classes. This will determine the amount you allocate to stocks.
- Then zoom into the stock portfolio and determine the amount to be allocated to each stock.
- Finally, tackle the position sizing issues of individual stocks.
I will explore the issue of how much to invest based on this framework.
Furthermore, the way a fundamental investor approaches investing is different from that of a stock trader. Different investment styles would approach the question of how much to invest in stocks differently.
How much to invest in stocks then depends on your asset allocation plan, your stock portfolio plan, and your investment style.
It is obvious that if you are indexing or investing in an ETF, some of the concerns of a stock-picker or trader would not be relevant. For this article, I will ignore the indexers and those investing in ETFs and mutual funds. Rather the focus is on the stock-picker or stock trader.
Contents
1. How to allocate your savings
2. How much to invest as a fundamental investor?
3. What is the min amount to start investing for a fundamental investor?
4. How much to invest as a stock trader?
5. How much to invest to become a millionaire?
6. Conclusion
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1. How to allocate your savings
If you know which asset class or stock will give you the best return, you will be an idiot not to invest all your savings into this one particular asset or stock.
By asset class, I mean a collection of investments with common characteristics. Examples of asset classes are stocks, properties, commodities, forex, and bonds.
In real life, we cannot foresee the future. So you spread your savings to several asset classes so that if one does badly, it would be offset by the better performance of the other assets.
I suggest that you group your savings into 3 categories or Buckets - Liquid assets, Safe assets, and Risky assets
1.1 Liquid assets
Examples of these are cash or bank savings. These serve as emergency funds so that you do not have to sell the other assets at the wrong time just to fund some unforeseen needs.
When you invest in stocks, you want to be in control of when to sell. You do not want to sell when the market is down. These liquid assets will give you some breathing space so that you don’t have to sell just to meet some cash requirements.
I have 2 years of my annual expenditure in this form. Look at your own lifestyle and allocate accordingly.
1.2 Safe assets
These are investments where the principal is protected. Examples are government bonds. For Malaysians, the Amanah Saham investments fall into this category.
There are 2 objectives with these investments. These serve as “floor net worth” in the event your investments in the risky assets tank. At the same time, they also perform better at times when the risky assets don’t perform well.
I have 8 years of my annual expenditure here. Consider your risk tolerance and allocate accordingly.
1.3 Risky assets
These are the ones that would be able to generate the best return among the 3 categories. But there is no protection for the principal. Prices here could also be volatile in the short term so you want to be able to live through such volatility. You achieve this by having the Liquid and Safe assets.
I would put stocks and properties in this category. I have the balance of my savings here. While I use the term ‘risky” there are ways to mitigate risk when you invest in such assets.
1.4 How much to allocate to stocks?
You can see that if you follow the 3 Buckets strategy, only a certain % of your savings would be allocated to stocks. This is turn would depend on your own profile - income, savings, lifestyle.
The key point is that the % is not set upfront. You should not start by saying that you would have a certain % for stocks. Rather the % is the result of working through the various asset allocation parameters.
Furthermore, look at the allocation from the savings or net worth angle rather than from the income level. In other words, don’t think of asset allocation in terms of % of income. This is because your income has to fund the various expenditures with the balance as your savings.
You will notice that I have moved away from specifically tying the asset allocation plan to income, age, and risk tolerance. I am not saying that these are not important. Rather I am saying that these should not be the main drivers of your choices. Rather they indirectly affect the amount you set aside for each bucket.
1.5. Other Investing rules
The above is of course not the only way to allocated your net worth.
There are other guidelines on how you can allocate your savings. Examples are the age rule, the 60:40 rule, and the all-weather portfolio. If you want a more detailed discussion on asset allocation, refer to “Baby steps in Asset Allocation for a Value Investor.”
Most of them are rules of thumb to help asset allocation. Furthermore, studies have been carried out to validate these rules. My objection against many of these rules is that they focus only on 2 assets - stocks and bonds.
When you consider that there are many types of investments, I find that these rules do not provide a comprehensive guide.
The 5 % rule
This is an investment philosophy that suggests an investor allocate no more than 5 percent of his portfolio to one investment.
This is not really an asset allocation rule of thumb. This is because if you follow this rule, you would have 20 different assets. Most people will have problems finding 20 different assets to invest in.
Rather this rule is meant for determining the amount to be allocated to a particular instrument within an asset class.
Using the rule for stocks suggests that no more than 5% of your total investing dollars should be invested in any single stock.
If you follow this 5 % rule equally, it means that you would have 20 stocks in your portfolio.
Note that the 5% rule suggests that you are not supposed to invest more than 5% of your investment portfolio in any one stock. It does not specify the exact amount you should invest. The 5% rule works as a limit, not a mandate.
2. How much to invest as a fundamental investor?
Once you have determined the amount to be allocated to stocks, the next question is how much to invest in each stock.
In asset allocation, you aim to spread your savings to several asset classes to balance between risks and returns. You should also adopt the same aim for your stock portfolio.
In other words, do not invest in only one stock. Rather have a portfolio of uncorrelated stocks. This is because if one does badly, the others may not do badly because of different economic and firms characteristics.
There is actually a mathematical relationship between the total allocated to stocks, the amount you invest in each stock, and the number of stocks you have.
For example, if the total amount allocated to stocks is $ 10,000 and you want to invest equally in 2 stocks, this would be equal to $ 5,000 per stock. If you invest equally in 5 stocks, the amount invested in each stock is $ 2,000.
The other mathematical issue is the link between returns and the number of stocks.
- If you have $10,000 invested in only Stock A that achieved a 20 % return, you would gain $ 2,000.
- If you have equal investments in 2 stocks in your $ 10,000 portfolio, only $ 5,000 would be invested in Stock A. The 20% return for Stock A would then amount to $ 1,000. To gain $ 2,000 for the portfolio, the other stock must also achieve a 20 % return.
You can see that with more stocks, it becomes more challenging to get the same dollar return. However, the opposite is also true when it comes to losses.
- If you only have one stock A in your $10,000 portfolio and stock A makes a loss of 20%, your portfolio loss would be $ 2,000.
- If you have two stocks in the $ 10,000 portfolio, the loss due to A is only $ 1,000. For the portfolio to lose $ 2,000, the other stock must also suffer a loss of 20%.
The example illustrates the following:
- The more stocks you have, the lower the overall dollar return.
- The more stocks you have the lower the risk of a permanent loss of capital
The number of stocks in a portfolio is then about finding the balance between risks and returns. By adding stocks to a portfolio that are not correlated with stocks already held, you can reduce the portfolio risk.
Studies have shown that the benefits of adding stocks to a portfolio decrease with the number of stocks in the stock portfolio. The benefits of diversification become marginal when you go beyond 30 stocks.
If you take these 30 stocks as the target, you can then determine the amount to be invested in each stock given a particular investment sum.
For further details refer to the following two articles:
2.1 Do you allocate an equal amount to each stock?
I have illustrated the relationship between the 3 key parameters of a stock portfolio.
- The total amount to be invested for the portfolio.
- The number of stocks in the portfolio.
- The amount to be allocated to each stock ie the position size.
The first is determined by your asset allocation plan. The marginal returns from diversification enable you to determine the number of stocks in the portfolio.
When it comes to position sizing, there are a number of factors to consider.
- From a risk management perspective, you should have some cap rules. This should be for individual stock and for groups of stocks making up particular characteristics eg industry, size, region. You could follow the 5 % rule.
- From a return perspective, the more you allocate to one stock, the more impactful its contribution to the portfolio return.
I generally do not advise allocating the same amount to each stock in your portfolio. You would only do this if you believe that all the stocks have similar risks and/or similar returns.
In practice, there are some stocks that you have more conviction. The guideline to determine how much to invest in each stock then boils down to investing as much as possible to the ones with the highest conviction, subject to the risk cap.
But in order to have a diversified portfolio, you should have 20 to 30 stocks and this determines the average amount to be invested in each stock.
In practice, I classify the 20 to 30 stocks into 3 groups based on conviction. For example:
- Group A would be those with the better conviction - allocate 6 % to 8 % of the portfolio value to each stock here.
- Group B would be those with the average conviction - the amount to be allocated to each stock would be about the portfolio average allocation.
- Group C would be those with the lesser conviction - each stock here will be allocated 1 % to 3 % of the portfolio value.
The total amount allocated to all the stocks would of course be equal to the portfolio value. I generally have about ¼ of the total number of stocks each in Group A and Group C. This means that half of the stocks are in Group B.
I do not use an exact formula to determine the amount to be invested for each stock because:
- As a bottom-up stock picker, the number of stocks in the portfolio is also dependent on whether I could find the stocks that meet my investment criteria. There have been occasions where I was hard-pressed to find 20 stocks.
- The position size is also affected by whether the stock is in the process of being build-up or sold off as I do not enter or exit a position in one go. Rather I do it over some time.
However, for those mathematically inclined, there is no reason why you cannot have a formula for the position size based on all the parameters that have been discussed.
2.2 How to determine the high conviction stocks?
If you are going to allocate different amounts to different stocks, you should have a consistent basis for such an allocation.
I have mentioned using conviction as the criterion. How do you define a high conviction stock? I look at the following parameters:
- The margin of safety. The greater the margin of safety the greater the conviction.
- Prospects. I classify stocks in terms of how challenging their business prospects are. I have compounders (those with strong moats) on one end and turnarounds on the other end. In between, I have the quality value companies and the Graham Net Net. I would have a higher conviction for the compounders compared with those facing turnarounds.
- Shareholders’ value creation. I use my Q Rating as one measure of the ability to create shareholders' value. The higher the Q Rating the higher the conviction.
At the end of the day, conviction is about your confidence in your fundamental analysis. It denotes your confidence that a particular stock would be a winner.
3. What is the min amount to start investing in stocks for a fundamental investor?
Since you cannot know for sure how a particular stock will perform, you invest in a portfolio of stocks. If you take the view that you need 30 stocks to have a diversified portfolio, it must mean that you should have enough funds to establish the 30 stocks portfolio.
In the Bursa Malaysia context, the minimum transaction lot size is 100 shares. Accordingly, the minimum amount to start investing is the amount required to buy 100 lots of shares in the 30 identified stocks. Based on an average price of RM 2.00 per share, this means that you will require at least RM 6,000 to start investing.
In some countries like the US, there are platforms that now enable you to buy even fractional shares. The issue of a minimum requirement is no longer tied to some “lot size” requirements.
Nevertheless, while you can buy one share or fractional share, from a risk mitigation perspective you should not invest in only one share. You should aim to have a portfolio from the start. This then determined the minimum amount you need to start investing in stocks.
When I buy shares, I determined my cost per share by dividing the total amount I paid by the number of shares. The total amount I paid included both the commissions and other government duties. Brokerage fees and duties are not exactly linear, ie there are minimum charges. This means that for purchases of a small number of shares, the brokerage and duties will account for a bigger % of the cost per share.
So, while in theory, you could buy one share or even a fractional share, you would have to aim for a higher price in order to make the same % gain as someone who bought a larger number of shares.
3.1 Is there any benefit of buying one share?
So far, we have looked at share ownership from a purely financial perspective.
However, if you consider investing as becoming part-owner of a company, then owning one share makes you a shareholder of a company.
This makes you eligible to attend the shareholders’ meetings and to vote at those meetings. If you are lucky, some companies have door gifts and discounts for those attending shareholder’s meetings. If this happens it is more than whatever financial gain you get from owning the one share.
There are some who think that for a newbie, owning one share helps to break the psychological barrier of investing in stocks. I am not sure whether this applies in the days of fractional apps.
4. How much to invest as a stock trader?
You will realize that the discussion in sections 2 and 3 are targeted at the long-term stock investor.
If you are trading in stocks, the amount you invest in each trade would follow a different set of rules. Yes, how much you invest is affected by your investment styles.
When it comes to trading, the differences are:
- Firstly, many brokerages have some rules about the amount you should have in your account (capital) to start trading.
- Secondly, trading expenses like commissions have a bigger impact on your returns. The smaller the amount you invest per trade, the bigger the commission impact.
- When it comes to trading, you don’t know whether a particular trade is going to be a winner or a loser. A loss can easily get out of hand if not controlled. To avoid this, you cap the risk on each trade.
The common rule is to risk not more than 1 % to 2 % of the capital on each trade.
Do not confuse this with the amount of share you can buy for a particular stock. Risking 1% does not mean that you can only utilize 1% of the capital in a trade.
For example, if you have $ 50,000 capital, you can lose up to $500 per trade if you risk 1%. However, you can still utilize all of your capital. If you buy 1,000 shares of a $50 stock, you have used all of your buying power. As long as you don't lose more than $500, your risk is less than 1%.
The easiest way to make sure you don't lose more than $500 is to use a stop-loss order. A stop-loss order gets you out of a trade when the price moves against you and reaches a pre-set price.
The rationale of setting the 1% risk amount is so that you can live to fight another day. You want to avoid a situation where a period of continuous losses wiped out your capital.
4.1 How do you determine the position size for stock trading?
Position size is how many shares you take on a stock trade. Position size is determined by a simple mathematical formula that helps control risk and maximize returns on the risk taken.
Position size = Amount of capital to risk / Amount to risk for each trade
For example, if you have $ 50,000 capital and you want to risk 1 %, then the amount of capital at risk is $ 500.
Assumed that that share price is $ 100 per share and you set your stop-loss at $ 98 per share. This means that you risk $ 2 per share for the trade.
The number of shares you buy or position size = 500 / 2 = 250 shares.
How do you determine the stop loss position?
One common way is to link it to the volatility of the stock using the Average True Range (ATR). ATR is a market volatility indicator that is typically derived from the 14-day simple moving average of a series of true range indicators.
ATR can be used in position sizing by calculating a multiple of the ATR to come up with a volatility-adjusted stop loss level. In order to size your trade, you then need to adjust your position size so that your maximal loss never will exceed your set limit. A good ATR multiple is often somewhere around 2-3 but varies with market and strategy.
For example, if the ATR for a stock is $ 1 and you decided to use a multiple of 2. Then the maximum amount of money you are prepared to lose on the trade = $ 1 X 2 = $2.
This then becomes your stop loss amount and if the amount of capital you risk is $ 500, the number of shares you buy = $ 500 / $ 2 = 250 shares.
4.2 How do you construct a stock trading portfolio?
If you are a stock trader, you do not approach a stock portfolio like a fundamental investor.
This is because your main risk control is the maximum amount of capital you risk at any given point in time. I would think the 5% rule is your starting point. In other words, 5 % is the total amount of your capital at risk at any time.
You can then determine the number of active trades to undertake at any point in time.
For example, if you risk 1 % per trade, it meant that you should have only 5 active trades. If you risk 2 % per trade, you should not have more than 2 to 3 active trades.
Essentially you do not follow the fundamental investor’s diversification concepts.
Secondly, given the relatively small number of stocks in the trading portfolio, you would select those stocks with the highest conviction. These would be those with the following combination:
- The best win-loss ratio.
- The best signal strengths.
As a trader, you probably rely on charts, trendlines, or other technical indicators to signal the price movement. The best signals could be those:
- Chart patterns that signal an uptrend if you are trading long.
- Trendlines with the strongest trend strengths.
- With the best confluence of technical indicators.
My point is that you need a consistent basis to guide your decision-making process.
5. How much to invest to become a millionaire?
So far, we have looked at how much to invest from the point of balancing risks and returns.
One very common question is how much to invest in order to be a millionaire.
This is a function of:
- Your starting amount.
- Whether you reinvest your gain to benefit from compounding.
- Whether you invest regularly.
- The returns you can achieve.
- The investment horizon.
I actually have an article “How to get rich from the stock market” that provides a detailed discussion on this question. Unfortunately, this article is only available to subscribers. So do become a member if you want to know more.
6. Conclusion
There are 2 dimensions in determining how much to invest in stocks.
- The investment styles. A stock trader would invest differently from a person investing based on fundamentals.
- The investment levels. Are we considering asset allocation, or constructing a stock portfolio?
From an asset allocation perspective, it does not matter whether you are a long-term investor or a short-term trader. The same approach applies.
But when it comes to constructing your stock portfolio and/or determining the amount to invest in a particular stock, the rules for a fundamental investor are different from those for a trader.
This is because the risk focus is different.
A fundamental investor would aim for a 30-stock portfolio. Then the amount allocated to each stock would be guided by whether he goes for an equal amount for each stock or based on some conviction rules.
On the other hand, a stock trader would focus on the maximum amount of the capital to risk, and the amount to risk per trade. The number of stocks in the portfolio follows from these.
You will realize that before you address how much to invest, you have to identify the stocks to invest in. If you are a fundamental investor, this will require you to analyze and value companies.
You may think that it is very challenging to do so. One way out is to then rely on third parties to do the fundamental analysis for you.
There are several financial advisers who provide such analyses.
Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.
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