Ask Colin

As your portfolio grows in size, when will you reduce the amount risked on any one stock below 1%?

Currently my maximum risk is 1%, but I rarely risk that much, because it truly is a maximum. Very small traders have to risk more than my 1%, because the number of shares they would be allowed to buy would be too small to be sensible. However, this problem falls away as total capital is increased.

One thing that limits how many shares I am allowed to buy at times is that I will not put more than 6% of my total capital in any one stock. As I build the position, the floor level is 2% of total capital. Often, this limits the number of shares I can buy, rather than the maximum risk.

However, beyond that, I think there is an important question which every investor has to answer. That is the balance of risks across their whole investment plan. Also, what is their own personal risk tolerance set against their objectives?

It is always possible, as the size of the portfolio increases, to reduce risk by staying with essentially the same dollar amount for each investment, but increasing the number of stocks in the portfolio. This will gradually reduce risk, because the dollar amount at risk will become a smaller and smaller part of the total portfolio. However, as always with risk management, there is a trade-off. The trade-off for reducing risk may tend to be reduced potential return. The more stocks we hold in the portfolio, the more diversified it becomes and the more its performance will approach the market return. While this might be the objective, Warren Buffett, Charlie Munger and others make the point that to beat the market we should try to do the opposite.

For me personally, the rules of a maximum of 6% capital allocated to each stock and a maximum risk of 1% of total capital on each stock is the level of risk that I can tolerate to try to beat the market return. For each investor the level of risk tolerance will be different. You can reduce risk, so long as you understand that you may also be reducing return. That is the trade-off.

One of the problems for anyone whose portfolio is increasing in size, especially if there are large jumps in it because of the addition of new savings rather than growth from investing, is that they will be less comfortable with investing larger and larger sums. I faced this problem in the last year when I actually doubled the amount of capital that I managed in shares in one go. It did take a while to become comfortable with the larger amounts. I took my time and built the amounts up and increased my comfort level over the year. I would never suggest that it is easy. Size does matter.