The 2% rule of investment
Just for fun, I decided to write a couple of blog posts on the way I make investment decisions.1
I have been investing my money ever since I graduated from school. I like to feel fully responsible of the fate of my money, so I do not rely on a portfolio manager. I don't hide that I lost money when I was just starting many years ago. But I learned quick enough and my investment returns became net positive eventually, and I have some confidence in keeping it this way based on the rules I follow.
How much can you afford to lose?
It may sound unsexy but first thing I write on this topic is my strategy on losing money. Before thinking about making money in investment, my advice always is to think how much one can afford to lose.
No investment is risk free. So, I suggest deciding how much money you can expose to risk. Here is a quick check:
- Keep track of your monthly expense including rent or mortgage, food, debt payments, insurance payments, and everything.
- Set aside 3 to 6 months of the monthly expense from your total savings as an emergency reserve in case you lose your income for an extended period.
- Consider investing the rest.
Here, I assume you have a steady income, and the debts are manageable if you have any.
- If you are not sure of your monthly expense, don't invest. Start keeping track of your money.
- If you still don't have enough emergency reserve, your life is on a big gamble. It's not time for you to take further risks.
The money left after subtracting the emergency reserve may be exposed to risks if you choose to do so. This is the total capital when I discuss 2% rule in the rest of this post.
The last check: make sure you have enough capital. $5,000 is bare minimum to start practicing, and $10,000 or more to make meaningful investments on stock markets.
The 2% rule
Here is a simple rule to follow when you decide how much to invest:
Never lose more than 2% of the total capital on one investment idea.
This rule can be applied to any asset class, or even for gambling. But let's take an example from the stock market. Say, you have $30,000 to invest in anything, and you wanted to invest in Exxon Mobil stock that is traded at $100. The 2% rule tells you that you should not lose more than $600.
Does it mean you can buy only 6 shares of Exxon Mobil? Not unless you are going to hold them until the company goes bankrupt, and the stock price becomes $0. 2
What one should do instead is to decide on what condition you will conclude the investment idea is wrong. Let's say if the price goes down by 8% or the stock price sinks to $92, you will admit you were wrong to think you could make money with the stock. You will sell the stock with a loss to protect yourself from the further loss.3
In the scenario above, you will lose $8 per share. So, assuming you would not fail to cut the loss, you can buy up to $600 / $8 = 75 shares. 4
Why 2%? Well, it is not an exact science. The idea is you can make 50 mistakes before you will completely lose your money. 5 Everybody, even professional traders make bad bets...a lot. The capital always swings up and down. The down swing should never hit the bottom, and only way to take control of that is to take a tight control over the loss. That is our No.1 priority.
Now that we defined how much we could lose, the next question naturally is:
Which investment is worth risking 2% of capital?
I will talk about it next.
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. ↩
It is not likely for a company like Exxon Mobil to go bankrupt over a short period of time. In fact, if it took 30 years for the company to go bankrupt, you might have already received enough dividends to make up for the initial investment. ↩
To make this automatic, you can (and you should) set so called stop-loss sell order to automatically sell your shares when the price goes below the pre-set price. Also note that this protection is not perfect in extreme market conditions. ↩
As long as you are OK allocating 25% ($100 * 75 = $7,500 out of your $30,000) in one stock. ↩
Your optimal bet could be 1% or even 5%, and it all depends on the expected return. In theory, one could calculate the optimal bet precisely, but it is not practical for a personal investor to do so partly because of the small sample size and partly because the odds for the future investments cannot be known before hand. ↩
Original post: Aug. 19, 2014 | Last updated: Aug. 23, 2014