Editor's note: Today, we're wrapping up our weeklong series of powerful trading ideas from master speculator Paul Mampilly, editor of our latest service, the Professional Speculator. In our final installment, Paul explains one of the most important things you need to understand to successfully make money in the market...
Friday, May 29, 2015
If you've been following my series this week, you've likely realized that understanding and limiting risk is the path to giant profits in the stock market.
As I've explained, the art of professional speculation is the process of reducing risk... It's about having a clear exit plan... and risking small amounts of money to make large amounts of money.
But there's another incredibly important part of every professional speculator's trading strategy... one that you must master if you're looking to take your trading to the next level...
I'm talking about practicing proper position sizing...
Simply put, position sizing is the part of your strategy that dictates how much money you'll place into any single trade. (If you place $5,000 in a trade, your position size is $5,000.)
Position size can also be expressed as a percentage of your trading capital. If you have a $50,000 account and you place $5,000 into a trade, your position size is 10% of your account.
Position sizing is based on the idea of portfolio diversification. It's all about finding the right balance. For instance, you wouldn't want to hold 400 stocks like some crappy mutual fund... but betting the farm on just one company is also a recipe for disaster.
This idea is incredibly important. Practicing position sizing immediately sets you apart from most investors.
Amateur investors tend to place way too much of their capital into just one or two stocks. If that huge bet doesn't work out, they suffer giant losses. For example, many people suffered huge losses in the tech bust in 2000 because they were "all in" on a few tech stocks.
Professional speculators never bet the farm on just one stock. They diversify across 10 or so stocks. They want to be in the risk/reward "sweet spot."
This position-sizing model is based on the principle that any single investment you buy can make you rich... but no single investment can bankrupt you.
In other words, professional speculators know that not every single stock or investment is going to soar. But some stocks will soar by 100%, 200%, or more. Heck, I've had a 2,000% winner in my personal account in the past.
The key concept speculators are trying to implement with their diversification model is this: A few big, huge, monster winners are going to make you rich. So you have to make sure you never bet your entire wad on just one or two stocks or investments.
You only put small amounts into each stock or investment you buy. Some of them won't be winners. But others could lead to massive gains.
For example, readers who followed my advice while I was an editor at Stansberry Research's corporate affiliate, the Palm Beach Letter, bought search-engine provider Yahoo for less than $16 in February 2012. Yahoo is now trading for more than $42, a gain of more than 160%.
In those same pages, I recommended medical-equipment company Boston Scientific for less than $6. Today, Boston Scientific is trading for around $18, a gain of 200%.
Now, the only way you benefit from big winners like these is if you follow a position-sizing model. If you go bankrupt or lose most of your money, you'll never get the chance to enjoy your winners.
When you buy, buy enough that any single investment can make you rich... but never buy so much that any single investment can make you go broke.
The rule I use in Professional Speculator is to not put more than 10% of your trading capital into any single stock.
Note: You would only put 10% into a high-conviction situation. That means most of the time, you should be putting in a maximum of 5%. By doing this, you'll always be invested in at least 10 stocks at any given time.
I've been using this diversification model for seven years... It comes from two and a half decades of actual, hands-on practice of the art of speculation.
If you follow this advice, you'll end up with a diversified portfolio likely made up of a few stocks that don't work out... a few with decent gains... and a few mega-winners. This will lead to a large average gain over the course of a year.
Learning to focus on risk instead of reward is a sea change for many people. But it's truly the difference between professionals and amateurs.
I urge you to take a look at your portfolio and make sure you have your own position-sizing model in place today.
"Of all the friends in the world a trader can have, one of the most valuable is the concept of position sizing," Stansberry Research Editor in Chief Brian Hunt writes. You can learn more about how to practice intelligent position sizing right here.
Along with having an exit strategy and practicing position sizing, Brian says there's something "everyone with money in the market should do at least once a year." Learn what this simple exercise is... and how it can drastically improve your trading performance in this brief interview.