Earlier this week, I went through my mailbag and this email from one of my readers stood out:
Dear Nick, another great idea. I’m going to break into my piggy bank and buy 300 shares of Amazon for about $490,000 at today’s price… Get real! This stock is for institutional buyers—pension plans and mutual funds.
Emails like this make me want to pull my hair out.
Now, Robert didn’t criticize me because he didn’t appreciate my recommendation of Amazon. As I wrote last week, it’s a great company trading at a significant discount. (See my January 8 essay, “This Retailer Took a Beating Last Year—Buy It Now.”)
In fact, he seems to like the idea. He’s just upset about Amazon’s nominal price.
At the time of last week’s write-up, Amazon shares were trading around $1,655. (It’s up about 1.2% since then—and up nearly 75% since my initial write-up in May 2017.)
So if Robert buys 300 shares on every investment he makes, then yes, his Amazon position size would be worth nearly a half-million dollars.
That’s a horrible way to manage your portfolio, though. Yet it’s a mistake that a lot of people make—one that can torpedo their retirement plans.
Today, I’ll show you how to structure your portfolio to maximize your gains and minimize your losses.
This is one of the most important lessons you can learn as an investor—because a badly structured portfolio can wreck even the best money-making opportunities.
A Common Mistake
For some reason, many investors believe they should buy the same number of shares for every position in their portfolios. I don’t know where this misconception comes from, but it makes no sense.
You’re not rewarded based on the number of shares you buy. You’re rewarded based on the amount of money you invest.
I believe investors make this common mistake because they don’t understand the simple concept of position-sizing. Position size simply refers to the dollar amount you allocate to each trade you make.
At Palm Beach Research Group, we generally recommend that you allocate the same amount of money to each of your positions—whether that’s $200, $2,000 or $20,000.
If you buy an equal number of shares per position, you’re putting more money into stocks with higher dollar values. In other words, shares with higher nominal prices will have greater weighting in your portfolio.
But stocks only deserve greater weighting if you think they’re better—not because they have higher share prices.
Let me explain…
Imagine you have a portfolio made up of two companies: ABC and XYZ. You position-size based on the number of shares.
ABC trades at $5 per share and XYZ trades at $100. If you buy 300 shares of each, you’d own $1,500 worth of ABC and $30,000 worth of XYZ.
Now, let’s say you hit a home run on ABC and it goes up 200%… while XYZ is a dud and loses 15%. You’d have an average gain of 92.5%—but your portfolio would be in the red.
By position-sizing based on the number of shares, you’d make $3,000 on ABC… but lose $4,500 on XYZ. That’s a total loss of $1,500.
But let’s say you have a $10,000 position size for each stock recommendation instead. In this scenario, you’d own 2,000 shares of ABC and 100 shares of XYZ.
If ABC goes up 200% in this scenario, you’d make $20,000 on that position. And if XYZ loses 15%, you’d be down $1,500. So your net portfolio gain would be $18,500.
Of course, this is a simplified example. But it illustrates the power of position-sizing based on equal dollar amounts, rather than equal share amounts.
How Many Shares You Should Buy
So Robert, Amazon is still a great idea. If you consider buying it, determine your proper position size, then allocate that amount to your trade.
For example, if a person can only allocate $5,000 per position in their portfolio, then they should consider buying only three shares of Amazon at its current price.
And there’s nothing wrong with buying just a couple of shares… I remember owning one $500 share of Google early in my career.
Position-sizing isn’t the most exciting topic in the world. But it’s one of the most important strategies you can master. It can be the difference between achieving a dignified retirement and living your golden years in the poorhouse.
Analyst, The Palm Beach Daily
P.S. Palm Beach Letter subscribers can read our entire position-sizing strategy in our annual Asset Allocation Guide right here.
If you’re not a subscriber, you can send your position-sizing questions right here. Remember, we can’t give individualized investment advice, so keep your questions general.
Palm Beach Trader editor Jason Bodner spent nearly two decades as a top trader for prestigious Wall Street firms such as Cantor Fitzgerald… He even mopped up $600 million worth of shares for a single client once.
Since then, he’s built his very own “13-X” private database to mimic how the ultra-rich practically mint money.