Ask Colin

How much of my trading capital should I commit to one stock?

This is a really good question. There are two aspects to this problem. The best known is the position size rule, which is to risk no more than a certain low percentage (0.5% to 2% depending on who you read, how they calculate the risk and how big your trading capital is).

However, the other aspect is how much of your capital to commit, assuming you are not risking up to the maximum of your position size rule. I once asked Dr Elder, who is prepared to risk 2% of capital on one trade, whether he would put all of his trading capital into one stock if he could do so without risking more than 2%. His answer was yes! Now, intellectually there is no problem with this - any trade that risks only 2% of capital is an equivalent risk.

However, if you think about it some more, there is an implicit assumption that you can get out at your stop-loss. However, in a market melt-down like October 1987 or an unforseen disaster for a single company, the price could fall way through your stop before you could get out. While this risk might be small, it is there and I think there is room for at least a minimum of diversification to deal with it.

More importantly, there is an aspect other than risk involved here. That aspect is opportunity cost. If you tie all your funds up in one trade, you cannot have any money working for you in other trades. That a means you had better be sure that you have selected the best opportunity to put your money into. Otherwise, it could sit there going nowhere, while other opportunities go begging. Personally, I cannot often spot the best one, so I try to spread my bets a bit, on the basis that some of them will be winners. I then increase my exposure to the winners and pull money off the losers.

Portfolio theory suggests that after you have 8 uncorrelated positions in your portfolio, further diversification only reduces specific risk (the risk attaching to a specific stock) marginally. However, all shares are to some extent correlated, so a fully invested portfolio needs to have more than 8 stocks, or include other asset classes that are not correlated to shares.

My rule is not to put more than 6% of my trading funds in any one stock. This will mean that when I am fully invested, I have at least 17 stocks and probably up to about 25 or 30. However, I never go above 30 - it is much too hard to watch them all and there is a strong psychological risk that I let some little losers run because the bigger positions are making money.

I hope this helps. It is such a good question, that I am going to use it in the next newsletter!