Save Yourself from a Stock Market Crash with this Simple, Free Strategy
How you can avoid being the best investor there never was, with an equation you haven’t probably heard of.
Let’s talk about principle.
When investing, you need principles. A person who invests without having a strategic plan or a set of rules is equivalent to making a donation. In this case however, you aren’t giving money to the Salvation Army or any reputable charity, instead you are handing money over to other investors who will gladly accept your shortcomings.
The most basic principle of any investment strategy isn’t a secret. Actually, it’s quite obvious… protect your principal. A principal, is not the guy in the office that you didn’t want to visit in grade school, but rather it’s the money you have at stake. I promised simple and easy so we will keep it simple in easy. Imagine…
… for a moment
You (an aspiring investor, with unfortunately no money to invest) find $10,000, while walking, on the ground. Your first thought, “Wow, quarantine isn’t so bad after all.” second thought, “Now I finally have some money to invest.” You hesitate because, after all, you just found $10,000, you do not want to lose it, and let’s face it, your investments in the past have been shaky at best.
Alas, the picture is painted, but don’t fret, we will get through this. Picking bad stocks for most is innate, and a stock market crash is a scary phenomenon… but investing is an essential practice for the growth of your net worth. So, now that we have established that you have $10,000 and you will invest, let’s discuss the principle of protecting your principal.
Establishing risk tolerance is another principle of investing. Some investors puke at the site of a dollar loss, while other’s enjoy the gratification of gambling on pink sheets. For most retail investors, a risk tolerance of 5% can be considered baseline, and that is what we will use today in class.
…Shhh, class is now in session.
Remember: You have $10,000 and we just established that your risk tolerance is 5%.
$10,000 with risking 5% of portfolio
$10,000 * .05 = $500 total riskSo you are comfortable risking $500, but the remaining money is the portion of the principal, which would drive you into a depressed state if you were to lose another dollar of it. Next, you conduct research and determine a balance portfolio consists of 8 equally weighted stocks. So… you find 8 different stocks to buy:
$10,000 / 8 = $1250 allocated for each stockThe question then becomes, how much do we risk per stock?
$1250 * .05 = $62.5 at risk per positionFor each of our positions, there exists the possibility that it could go up in price or down in price. We have already determined that we do not want to expound more than $500. For each position that means, that if the stock goes down by more than 5% or the position size decreases by $62.5, then we are in danger. So how do we protect our principal?
Now introducing…
The stop order, and his cousin the trailing stop order. By placing a stop order at a price point of 95% of the price of your initial purchase price, a market sell order will be placed when the price of the stock hits the amount. A trailing stop order automatically adjusts the sell price based on a limit you select. By implementing stop order or trailing stop orders, you can ensure that your principal stays protected and you do not accept any risk that you cannot tolerate.
Another option is setting alerts at each of the aforementioned levels. You then have the option to decide whether or not to make the sale to conserve any unforeseen losses.
To calculate position size, I’ve included the bonus equation below:
Risk Amount = $62.5
Stock Price = $100
Stop Price = $100 * .95 or $95
Position Size = Risk Amount / (Purchase Price - Limit Price)
Position Size = $62.5 / ($100 - $95) = 12.5 Shares to Purchase…That’s enough teaching to get you started. Play around with the numbers but be mindful of the two principles — protect your principal and determine your risk tolerance. If you determine, that you only want a portfolio of two stocks, and one carries more risk than the other play around with the numbers to adjust for the risk accordingly. I’ll leave that up to you for homework. Implementing this equation may just help you survive the next big crash.
Thanks for reading!