Which investment is worth risking 2% of capital?
Four buckets of investment
I was thinking about the 2% rule as I mentally construct this post, and I decided that I should write a little more details on when I actually apply the rule.
The first work I got after the school provided 401k. So, part of my investment capital went to the retirement account, and rest went to the non-retirement investment account. Since the retirement account was not very flexible on what to invest, it was used for long term and lower risk investments. The non-retirement account instead was used for short to mid term and higher risk investments.
As I changed my job, I moved the 401k account to Rollover IRA in the same broker as the non-retirement account where I have much better control. Now I have enough investment capital, so I divide it into 4 buckets based on the different objectives and strategies:
- Super long term: Value focused. Secular stocks. Weighing on dividends. Almost never sell. Blue chip stocks in the developed countries.
- Long term: Cyclical sectors to take advantage of the stock price appreciation in the current phase of the economic cycle.
- Mid to short term: Investments based on growth strategy.
- Short term: Speculative bets.
For Buckets 1 and 2, I use my retirement accounts4. I usually use the non-retirement accounts for Buckets 3 and 4. When I calculate 2%, the base is the total amount from all 4 buckets. But I apply the 2% rule only to Buckets 3 and 4, where the risk is higher and it is always clear when I make wrong investments.
With this arrangement, I gain consistent small steps of growth with Buckets 1 and 2, moving with the rest of the world. Then I try to get ahead from others with Buckets 3 and 4. That is the idea.
Investment decisions on mid and short term positions
If we have 50-50 chance of making profit or loss, we need to make more than 2% of return in the success scenario in order to make the expected return positive.
Let's go back to Exxon Mobil stock hypothetical example from the last post:
- The total capital is $30,000
- Buy at $100, and cut loss when the price goes down by 8% or $92
- To risk 2% of the capital ($600) in this investment, we by 75 shares ($7500)
To break even with the expected return, we have to believe there is at least 50-50 chance that the stock price hits $108.
This does not make the idea worth risking 2% yet. Why? One obvious reason is this merely make our expected return to be zero:
- -$600 * 50% + $600 * 50% = $0
If we hold the position and do nothing until either outcomes (i.e. the stock to hit $92 or $108, the result will never be $0 in reality. But if we repeat the investment of the same condition repeatedly, the gain or loss will average to zero.
Who would bother such investment? In fact, the true expected return would be negative as the profit would be taxed. Say, one gets taxed by 28% for the short term capital gain. The potential profit must be 2.78% or more to be truly break even5. There is also a fee for the broker for both buying and selling the shares in most cases.
Remember that I am applying the 2% rule for short-term (and speculative) or mid-term (and growth focused) positions to get ahead of the game. So, if my after-tax gain is only 2%, I'd rather put my money in the value stocks to earn 2% dividends. So, the investment ideas I would consider have to have a big asymmetricities of potential profit and loss.
Never move until the real opportunity comes
In such investment idea, the stock must move quite a bit, or the volatility must be very high in other words. Say, I want to find an investment idea that would get me the total capital growth by 4% upon winning before paying tax. It is a gain of $30,000 * 4% = $1,200. With our hypothetical Exxon Mobil stock example, the stock price needs to hit $1,200 / 75 shares = $116. That is 16% of appreciation! That much move in a relatively short period of time would not happen very often with the stock of stable companies like Exxon Mobil.
In fact, it's rather rare for me to spot such big price movements. So, I do several things:
- Just sit tight until I see a truly attractive opportunity.
- Do better than 50-50 odds of winning so I can lower the criterion for the potential gain. Then I find more opportunities.
- Trade often whenever we see a positive expected return even small ones. And hope the accumulation of repeated trade will be worth the effort over a year1.
- Use leverage to inflate volatility2
I combine a bit of all options above in practice. All of them requires me to research the markets, have more sophisticated strategy, be more rigorous in calculating risk, and be more disciplined in execution.
It surely takes time and effort. So if this is not for you, my suggestion is to make steady amount of investment to diversified assets every month or quarter, just the way I do for my investment buckets 1 and 2.
Just to avoid ending just talking theory, I will show a couple of examples from my recent investments in the next post.
If we repeat 0.5% gain 10 times, we get more than 5% compound returns. ↩
I don't have energy to explain this now, so just a take a look here: Leverage (finance) - Wikipedia, the free encyclopedia ↩
I am not a professional financial advisor. Trading and investing carries a high level of risk and may not be suitable for everybody. Before deciding to trade or invest, you should carefully consider your financial objectives, level of experience and risk appetite. Any opinions, news, research, analyses, software, tools, prices or other information contained herein is intended as general information about the subject matter covered and is provided with the understanding that I am not rendering investment advice. ↩
Except for the Roth IRA account. I use Roth IRA for shorter term positions because I don't have to pay capital gain taxes if I do so. ↩
2.00% / (100% - 28%) is about 2.78% ↩
Original post: Aug. 22, 2014 | Last updated: Aug. 23, 2014