Risk Reduction With Allocation
Every stock is unique and trades in its own unique range. Let me make up a simple example with a three stock portfolio to show how risk can be distributed more fairly.
Stock A is tradiing from $20 to $25 in the last 90 days
Stock B is tradiing from $20 to $40 in the last 90 days
Stock C is tradiing from $20 to $60 in the last 90 days
Let's say you want to invest $30,000. Many investors would buy $10,000 of each stock. If you use the trading range with buy and sell stops, the risks of each stock are uneven. Assume all stocks tank and go straight down, what is the loss for each?
Stock A we would have 400 shares and the loss is 400 x (25-20) = $2,000
Stock B we would have 250 shares and the loss is 250 x (40-20) = $5,000
Stock C we would have 167 shares and the loss is 167 x (60-20) = $6,666
Even though we puchased even amounts of all three stocks, the risk we purchased was not even. You can use a spreadsheet or a formula or a calculator, and get close to a more fair initial risk.
700 shares of Stock A = $3,500 risk and $17,500 cost
180 shares of Stock B = $3,600 risk and $7,200 cost
90 shares of Stock C = $3,600 risk and $5,400 cost
total cost $30,100
This is a more even distribution of initial risk. I go into this in greater detail in chapter 14 and show the groovy formula made for me by my good friend Bruce "Math Ninja" Chidley. He made up a formula to quickly do this allocation.
