Ask Colin

How much capital do you allocate to any one stock if your market exposure strategy setting is to have only 50% of your capital invested in the market?

My maximum capital allocation to any one stock is 6% of my total capital. That means that if my total capital is $500,000, I would invest up to $30,000 in any one stock. In very general terms and assuming that my risk per stock of a maximum of 1% of total capital allows it, I would build such a position in three $10,000 lots.

This would be the same whether my market exposure strategy setting was 100% invested or some lower percentage, like the 50% that you postulate.

The reason is because my diversification strategy is to have no more than 6% of my total capital in any one stock, which means a minimum of 17 positions if I am fully invested. Note that I am expressing my diversification in terms of a maximum percentage of my capital, not the number of stocks.

You can think of it this way: Diversification is to manage specific risk. Specific risk is the risk associated with any one stock. That risk is the same whether it is the only stock in my portfolio or one of 17 or more stocks.

The other approach is to think in terms of 6% of my invested capital. If I had only 50% of my capital available to invest, that would give a position that was half of what I described above. One implication of this is that if I subsequently change the percentage of capital I have invested, I would have to keep rebalancing the portfolio. This would have a detrimental effect on transaction costs.

Another problem is that I may no longer be playing for meaningful stakes, which is an integral part of my investment plan. It would be changing the balance of risks across the plan.

Now, what I do is not the only way to invest and I would never claim it was the best way. I don't think that concept has any relevance when you consider that every investment plan must be designed to suit the investor who will manage it. There is nothing to stop you having a plan that allocates capital to stocks differently, so long as you have thought through the implications for the balance of risks you have decided to assume.

In your extended question you said that doing what I do "plays havoc with [your] stops". I wonder what you are doing here, because it makes no difference to me. I set my stop-loss price level based on the chart. The risk back to my stop determines the maximum number of shares I am allowed to buy. I continue to use the total capital to determine my maximum risk, so it makes no difference to the stop-loss price level or the number of dollars risked. If you were to use the invested capital (50% of total capital) to determine your risk, then all it would mean is that your maximum number of shares you are allowed to buy would be halved. It does not alter the stop-loss price level. It alters the maximum number of shares you can buy.

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