Determine your Risk Tolerance
Defining our risk tolerance is one of the first things that investors should do before entering the market. And this exercise should be done with honesty.
An investment strategy will provide you with the framework and will tell you “how” to invest and “where”. However, “why do you invest” is a prior question, ‘Why’ is not about making returns, it is about the purpose of your investment. Few investors know why they invest. 🧐
Are you building up capital for retirement? Are you already retired and want to make some money from your savings? Both are not compatible.
The RQM strategy has been designed for people who want to see their capital growing at a modest but steady path. Conservative investors in an accumulative stage of their financial life.
Knowing your risk tolerance
One of the positive points of investing in the stock markets (long) is that the losses are limited – you can only lose everything -, whereas the potential profits are infinite. The sky is the limit.
It’s quite common to find stocks increasing two, three, ten-fold within a few years. They are known as “x-baggers”. Actually, the vast majority of companies in the big indexes like the S&P 500 have been “x-baggers” at some point and have been growing fast for a long time. Otherwise, they wouldn’t be there.
But at the same time, it’s also true that nothing is eternal. Technological disruptions, political shifts, changes in consumers’ taste, the macroeconomic environment… The reasons why things might change, slowly or suddenly, and go wrong are so varied and particular in each case that it’s not worth even paying attention to them.
Let’s simply assume the reality. All companies have cycles. The key question is:
How much are we going to bear a down cycle? That’s our risk tolerance.
Amount to invest 💰
The first variable to consider is the total amount to invest, the capital. It sounds obvious, but many investors don’t set it up upfront. Novice investors start buying some stocks, maybe 2 or 3, just to try. Then, if the experience is successful, most likely they are tempted to seek more opportunities. On the other hand, if they suffer a pullback, they will be tempted to acquire more shares of losers to average them down. But in both cases, neither the total amount nor the strategy is pre-defined.
So, set your Total Capital at the beginning.
Doesn’t matter if you don’t have it yet and you plan to get there through periodic contributions. Define it and write it down in stones. Without that amount, the following questions can not be answered.
Of course, it also implies that the money you want to put on the stock market it’s an exceedance and you won’t need it to cover whatever contingency. All your expected expenses at mid-term should be covered.
Risk assumption per position
The Maximum Loss per position can be defined as a percentage of the capital or as monetary value. As a general rule, never risk more than 2% of your capital on a single position. However, being conservative as we are, in the RQM strategy our maximum loss is 1% of the capital.
From the other side, on the StopLoss post, we argued that it’s reasonable to assume a dropdown of 15-20% as normal.
Then, keeping those 3 elements in mind, Capital (K), Maximum Loss (MaxL), and the Expected Dropdown (DD), we can derive the size (S) of each of our positions.
$$ S =\frac{MaxL}{DD} * K$$
Obviously, assuming an equally weighted portfolio.
Examples
Example | Capital | Max Loss | Drop Down | Position Size | Number positions |
---|---|---|---|---|---|
1 | 25'000 | 2.0% | 15.0% | 3'333 | 7.5 |
2 | 50'000 | 1.5% | 15.0% | 5'000 | 10 |
3 | 100'000 | 1.0% | 15.0% | 6'667 | 15 |
4 | 200'000 | 0.8% | 15.0% | 10'667 | 18.75 |
5 | 500'000 | 0.8% | 20.0% | 20'000 | 25 |
For small amounts (example 1), maybe it’s worth risking more, up to 2%. Actually, for those young investors, I would suggest looking for another strategy, more focused and less conservative to be able to grow their capital quickly. But for higher amounts, the advice is to stick to the 1% or even less. Example 3 (100K) would be the default of the RQM strategy. On the other side, for investors with capital > 500 K, other strategies like dividend growth might suit them better.
Total Maximum Loss
Knowing each moment the maximum amount one can lose helps investors sleep better. Definitely, it’s my case. I like going to bed knowing the exact amount I can lose overnight. All my positions have a stop-loss in place following the rules above.
I know that enforcing such a structure can lead to inefficiencies. A deep-value long-term investor might freak out here. But believe me, we are humans. Thank God we do mistakes and we suffer cognitive biases. And we like to have relaxing sleep. Then we have to pay some price for it, don’t you think?