Registered Investment Advisor Firm
©Issue VII, Vol. II – Bud Heng – Registered Advisor (925) 360-6819
JULY – 2013
What’s 4 Times 62.5%?
5% more per year than all the goods and
services we produce.
If the national debt to Gross Domestic
Product (GDP), the sum of all the goods
and services produced, were to equal
62.5%, most would probably say “wow
that’s getting kind of high, maybe we
should look for ways to reduce that
percentage a little.” Well the good news
is, I’m not talking about the U.S., I’m
talking about Japan.
We all remember the anxious moments
surrounding Greece and how the
turmoil in their bond markets affected
global exchanges. Greece’s economy is
ranked somewhere between 34th and
45th in size as a global economy. So if
the world is to see another global bondmarket panic, Japan, as the most
indebted large democracy, is a likely
place for the panic to begin.
That’s right, the Japanese government’s
debt has grown so large (almost 250% of
GDP) that for the last several months,
their government has been forced to
borrow additional sums merely to meet
its interest payment obligations. That’s
like using your charge card to take a
cash advance in order to make your
charge cards minimum monthly
payment.
Like the U.S., rather than cutting the
size of their government and reducing
their borrowing, the Japanese central
bank has been printing huge sums of
money. And it’s been buying
government debt to help finance the
country's huge deficits which currently
runs at about 10% of its GDP.
In essence Japan is literally bankrupt,
and Japan is the world’s second largest
democratic economy behind the U.S.
The U.S. is plodding along at about
105% of GDP which means we only owe
Like the U.S. under quantitative easing
(QE), the result of this money and credit
stimulus was predictable. Stock prices
have gone up (at least temporarily) and
personal consumption has increased
since people would rather spend money
This publication is intended for informational and educational purposes only. It is not intended nor should it be construed to
be an offer of investment advice and any mention of a stock, bond, mutual fund, ETF or other investment vehicle should not be
considered an endorsement or recommendation. Investment returns if referenced are based on past performance and should
not be considered an indicator of future results. You should carefully assess your own circumstance, conduct your own
research or consult your investment advisor before making any investment decision based on any material presented.
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now before prices start going up due to
inflation.
into a trade. In short, position-sizing
essentially tells you how much.
However, when you’re bankrupt and
you deliberately destroy the value of
your currency, eventually everyone
begins to sell. Currently Japan has
begun to experience a trade deficit for
the first time in memory. Because of the
trade deficit, Japan is forced to get
foreign financing for its government
bonds. So far, they have been able to
find limited buyers. The U.S. has also
sought foreign buyers for its bond
issues, but it’s far easier for the U.S.
because more than 60% of the world’s
bank reserves are held in U.S. dollars.
Position-sizing is only half of the
equation however. The other half is
knowing and establishing your “stoploss,” or the price you decide to exit a
trade because it has moved against your
expectations. In investing, many find it
much easier to enter a trade and much
more difficult to exit that trade
sometimes leading to large losses. Many
professional money managers know
their exit price-point before they even
make the purchase.
What’s More Important – The
Position or the Size?
I’m talking about position-sizing when
buying equities - what is it, how it
works and why it’s important.
First off, money management can be a
very confusing term. It typically means
many different things to different people
depending on their unique
circumstances. For instance, for
someone who manages their own
portfolio the definition is probably very
different from someone who uses a
professional in order to manage risk,
maximize gain or generate income – the
list goes on.
In this context I’m going to address
money management in terms of
position-sizing to give you a sense and
perspective of how many money
managers help decide just how big a
position should be taken when entering
The importance of keeping losses to a
relatively small percentage is very
important. Many investors may look at
the percentage as a fraction of their
entire portfolio while others may isolate
the percentage to just that particular
stock, bond, mutual fund or ETF.
For instance, assume you decide to enter
into a trade to buy 300 shares of ABC
stock at a price of $20 per share. Your
capital investment (excluding trading
costs and commissions) is $6,000
($20x300). Your investment then losses
10% and falls to $5,400. Over the next
few months ABC stock rebounds 10%,
so you’re feeling good because you’re
back to “breakeven.” NO YOU’RE NOT!
Up 10% from $5,400 is $540, you’re still
$60 below your acquisition price. Does
the $6,000 capital investment equal
100% of your available capital or is the
$6,000 some fraction of a large pool of
investable capital? The answer to that
question is crucial to your success.
Perhaps a better way to explain this
might be to consider the impact of a
This publication is intended for informational and educational purposes only. It is not intended nor should it be construed to
be an offer of investment advice and any mention of a stock, bond, mutual fund, ETF or other investment vehicle should not be
considered an endorsement or recommendation. Investment returns if referenced are based on past performance and should
not be considered an indicator of future results. You should carefully assess your own circumstance, conduct your own
research or consult your investment advisor before making any investment decision based on any material presented.
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price decline of 50%. You now have to
have a 100% recovery to just
“breakeven.” The larger the loss, the
harder it is to make up the lost ground.
If you employ adequate measures to
minimize “drawdowns” (losses) to the
overall portfolio, then you might find
those comfortable using 20%, 25%, or
even 35% “trailing-stops” (sell prices
that move up as your equity position
increases in value). However, most
professionals will make a determination
based on any number of variables as to
what the risk/reward potential is before
entering the trade. It wouldn’t make
much sense to risk 35% for the potential
of a 10% gain.
Once a trader has established the
discipline to set and stick to their stop
loss on every trade, the most important
area of trading is position-sizing.
Position-sizing is the part of your
trading system that tells you how many
shares (or contracts for futures or
options) to make per trade. Poor
position sizing is the reason behind
almost every instance of account
blowouts.
Let’s go back to the example above.
Imagine that you had $100,000 to trade.
Many traders might jump right in and
decide to invest a substantial amount of
this equity (perhaps $25,000) on ABC
stock because they were told about it by
a friend, or because it “sounded” like a
great buying opportunity.
Or they decide to buy 10,000 shares of
ABC stock because the price is only $4 a
share ($40,000). They have no preplanned exit or idea about when they
are going to get out of the trade if it
happens to go against them and they are
risking a substantial portion or
percentage of their initial $100,000
unnecessarily.
Now let’s assume that with the same
$100,000 portfolio you decide to only
risk 1% on any trading idea that you
have. You’re risking $1,000, but it’s
important to distinguish that the $1,000
is the amount risked on the trading idea
(trade) and it should not be confused
with the amount that is actually
invested in the trading idea (the trade).
The $1,000 is your limit at risk.
Now suppose ABC stock is trading at
$23 per share and you decide to place a
stop-loss order 25% below your
purchase price. If ABC drops to $17.25 a
share, you’re out of the trade, the stock
is sold. In this example your risk per
share was $5.75 per share of ABC stock.
Since your risk is $5.75, you divide this
value into your 1% allocation ($1,000)
and find that you are able to purchase
174 shares, rounded down to the nearest
share for a total investment of about
$4,000. This means you’re purchasing
$4,000 in ABC, but you’re only risking
$1,000 or 1% of your portfolio. No one
likes to lose, but if you didn't have the
stop-loss and the stock dropped to $10
per share, your capital would begin to
vanish very quickly.
Let’s assume you decide that if you make
10% on your trade in one month, you’d
be happy to protect your profit and exit
the trade, after all on an annualized basis
that’s a 120% return. Sounds great
doesn’t it? But let’s look a little closer at
This publication is intended for informational and educational purposes only. It is not intended nor should it be construed to
be an offer of investment advice and any mention of a stock, bond, mutual fund, ETF or other investment vehicle should not be
considered an endorsement or recommendation. Investment returns if referenced are based on past performance and should
not be considered an indicator of future results. You should carefully assess your own circumstance, conduct your own
research or consult your investment advisor before making any investment decision based on any material presented.
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this trade. We have put at risk $1,000 to
make $400 in profit. That’s a “riskreturn-ratio” (RRR) of .40. So how can
we improve our RRR while maintaining
our desire to only risk $1,000 on this
trade?
If we use the same ABC stock priced at
$23 per share and move our stop-loss to
$21.50, we are now risking $1.50 per
share. In order to meet our desire to risk
$1,000 on this trade, we would need to
purchase a total of 667 shares of ABC
stock for a total of $15,341. Our RRR is
now 1.53 instead of .40 and if we decide
to exit the trade after a 10% profit we
have made a total of $1,534, almost 4
times the profit of the first scenario
while only risking the same $1,000.
Now you might be thinking this sounds
way too complicated and hard to
calculate position-sizing, the “riskreturn-ratio,” etc. I have a solution I’m
willing to share with you for the asking.
It’s an excel spreadsheet that calculates
all these numbers for you. All you need
to do is indicate the amount of equity
you want to invest, the percentage you’d
like to risk, the entry price, your exit or
“stop-loss” price and your RRR. The
amount of shares and profit will be
calculated for automatically for you. I’ve
provided a picture here:
If you’d like to receive a copy of this
spreadsheet for you own personal use,
you can download it from my page at
DavisInvestmentGroup.biz. If you
decide to take advantage of this offer,
note that the white cells can be edited,
however any editing to the colored cells
will render that particular line of the
spreadsheet inoperable. I hope you
enjoy it and would appreciate any
feedback.
Davis Investment Group
Davis Investment Group is a fee-based
Registered Investment Advisor firm
servicing the needs of clients across the
United States. Davis Investment Group
custodies all client assets at Charles
Schwab & Co. Davis Investment
Group’s home office is located at 714
Marin Street, Suite #C, Vallejo, CA
94590. The telephone number is (707)
648-2024.
If have questions or would like further
information on this month’s topics,
please contact me directly at (925) 3606819 or through email at:
Bud@DavisInvestmentGroup.biz
This publication is intended for informational and educational purposes only. It is not intended nor should it be construed to
be an offer of investment advice and any mention of a stock, bond, mutual fund, ETF or other investment vehicle should not be
considered an endorsement or recommendation. Investment returns if referenced are based on past performance and should
not be considered an indicator of future results. You should carefully assess your own circumstance, conduct your own
research or consult your investment advisor before making any investment decision based on any material presented.
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