“All men can see these tactics whereby I conquer, but what none can see is the strategy out of which victory is evolved.” – Sun Tzu
Principles of Wealth #34*
According to the financial planning community, asset allocation is the single most important factor in building wealth. This is misleading. The most important factor is actually risk management. Asset allocation is just a part of risk management. The other two parts are position sizing and loss limitation.
Risk is an element of every investment transaction. But if you know what you’re doing, most of it is unnecessary. And by knowing what you’re doing, I mean following the “best practices” I’ve discovered over the years.
Asset allocation means dividing your investment capital into different asset classes. By doing that, if one asset class tumbles, you have money invested in other classes that may not drop as fast… or may hold strong… or may even increase in value.
To show you how important asset allocation is, let’s look at would have happened to two investors in 2008.
Our first investor is “Joe.” He had 100% of his money invested in the stock market in 2008. Let’s say $100,000. In other words, he had no diversified asset allocation plan, and his money was wide open to stock market volatility. So when the S&P 500 dropped 37% that year, Joe lost $37,000.
Our second investor, “Nancy,” also had $100,000 invested. But she took a more conservative approach. She followed the traditional Wall Street asset allocation model – 60% in stocks and 40% in bonds.
Like Joe, Nancy lost some money when the S&P 500 dropped 37%. But she had fewer of her dollars in the stock market. Therefore, she lost less than Joe did. That alone makes her strategy superior. But it gets better…
Bonds are typically inversely correlated to stocks. And in 2008, when the stock market was plummeting, bonds rose 5%. So while 60% of Nancy’s money dropped 37% (her stock market losses), the other 40% of her money rose 5% (her bond gains). So Nancy actually lost only 20% of her money in 2008, or $20,000.
Had you invested your money with the “average” financial planner back then, this would have likely been your outcome. That’s why the two-asset class “Wall Street” model is far from optimal. And that’s why I recommend reducing your exposure to stock market risk with an expanded asset-allocation strategy that includes such things as real estate, gold, cash, and entrepreneurial businesses.
Position sizing is a simple strategy dressed up in a fancy name. The idea here is to limit risk by deciding you won’t put more than $X or X% of your capital in any single investment.
Where asset allocation reduces overall risk, position sizing reduces the risk within each asset class.
If, for example, you had $800,000, you might put $100,000 in each of eight asset classes. That’s asset allocation. Position sizing would determine how you divide the $100,000 in each asset class between individual investments.
You might say that you’ll invest no more than $8,000 in any one deal. $8,000 is 1% of $800,000. So if one investment of $8,000 went down to zero, your Free Net Wealth ($800,000) would go down by only 1%.
Like asset allocation, position sizing is a way for conservative investors to protect themselves from catastrophic losses. I’m a strong proponent of position sizing. This is an important safeguard – especially if you ever find yourself wanting to “go big” on some gamble.
Keep this in mind: The smaller you can make your position limit, the safer you will be. My position limit is 1% of my Free Net Wealth on many of my stock investments. But when you are starting out, it will be hard to set such a small limit. A good rule of thumb for most people is 3%-5%.
When you use position sizing to buy stocks, you are limiting your potential losses to a percentage of your portfolio (1% for me – maybe 3%-5% for you). But you can further reduce your risk by attaching a “stop loss” to each stock you buy.
A stop loss predetermines the price at which you will sell a stock if its price drops that low. If, for example, you set a 25% stop loss on a $20 stock, you will sell it if its price drops to $15. This reduces your risk for that stock to 25% of its position size.
Getting back to our earlier example and assuming that you have $8,000 invested in the stock (your position limit)… If the stock’s value dropped 25% to $6,000, you would sell it. You would take a loss of $2,000 and no more. And if, as in our earlier example, you had a total of $800,000 invested, your total loss on that investment would be only one-quarter of 1% of your Free Net Wealth.
Stop losses allow you to control what you are willing to lose. They remove emotion (an investor’s great enemy) from consideration when a stock, a group of stocks – or even the entire stock market – is tumbling.
And as you can see, when you combine stop-loss limits with position sizing, you reduce risk dramatically.
* In this series of essays, I’m trying to make a book about wealth building that is based on the discoveries and observations I’ve made over the years: What wealth is, what it’s not, how it can be acquired, and how it is usually lost.