The 1% Rule Can Help

11/21/2011 7:23 am EST

Focus: STRATEGIES

A.J. Monte

Chief Market Strategist, The Market Guys, Inc.

It’s a very simple, time-tested way to limit your risk when investing, and A.J. Monte explains his slight tweak of the strategy that makes it even more useful in this exclusive interview with MoneyShow.com.

Are you concerned about managing risk in these volatile markets? Well, A.J. Monte has a 1% rule for you, let’s talk to him now. Hi, how are you doing?

Good, thank you.

And now, let’s right away jump into this. You know the markets are very rocky and everybody is worried. Some people want to sell and some people just don’t want to pay attention to the market today. You have this little technique that you think is helpful to people, this 1% rule. Can you explain that?

Sure, it’s worked for me for over 30 years, and I started trading commodities in the World Trade Center trading gold and silver.

So a lot of the professional traders, even if you speak to them now in these volatile conditions, will tell you that the key to success is not so much picking the right investment, it’s knowing when to get out when a bad investment goes against you.

So what I’ve done is I’ve embraced the 1% rule. It’s something that has actually been around for a while, and I can’t say that I came up with the formula. It’s just something that’s worked.

I don’t think anyone has actually claimed it, but we’ve modified it to the point where it’s easily calculated and could be used by virtually anybody, whether you’re a professional money manager or just a private investor or trader for your own account.

So, how does it work? So you sell when it’s 1% down?

Not necessarily. I’ll use a model account of, let’s say, $100,000. You have a $100,000 account, you take 1% of that, which is roughly $1,000, and if I were to put that in a simple statement, it would state, "I—whoever the trader is—will not lose more than $1,000 on this particular investment," and that’s calculated per position.

OK, so alright, I understand now. So let’s say you have ten positions in that account.

Yes.

Right. And each one is $10,000.

Well, that would be $1,000 per position. So if you have ten positions, you’re not willing to lose more than $1,000 per position, so if you’re wrong on all ten, you’re going to lose $10,000 if you’re doing it correctly.

And if you’re wrong on all ten, you need to talk to me, because you’re doing something wrong with the stock selection.

Yeah, you need to change your portfolio.

Right.

OK. So essentially what you’re talking about is that you limit the risk on any one position, but you’re setting a dollar amount of it as a percentage of your whole portfolio.

Yes. That’s where it starts. So the $1,000 is determined to be the risk amount. That’s the 1% per position.

But there is more to the formula than that, because we need to look at a technical chart to determine where support level is for that stock, because you have to now determine what your risk per share would be. So let’s use another example.

Why are you making it more complicated? The 1% is so simple for people to follow.

Well, because if you’re buying a stock and you’re stopping yourself out at 1% per account, you may find that your stock is going to go 1% against you in the value of your account—not share price, but 1% against you—and then all of a sudden it hits support and it goes off, and you get stopped out and you never should have gotten sold out.

So, let’s say you have a $40 stock that you want to buy. Let’s say that you buy 1,000 shares of that $40 stock, so you spent $40,000 of your portfolio. Again, this is an example.

Right.

If we determine that the support level for that stock is at $39 and you bought it at $40, you’re going to want to put a stop-loss order somewhere below support.

So let’s say you put that stop loss below $39 and you set it at $38. Now, your risk amount is $1000. But the risk per share is now $2 per share.

Now here’s the key to this whole equation: Most people, when they get involved in stock, they look at their portfolio and they say, "OK, I have this much to spend," which is buying power, and they shop based on how much money they have in their portfolio.

So what this formula also does for you is it allows you to calculate the number of shares. We call that sizing the position. So if I buy a stock and I’m willing to let it go $2 against me, how do I determine how many shares I get to buy?

Well, I take the risk amount, $1,000, divide that by the risk per share, which is $2, and that tells me that I get to buy 500 shares of that stock.

Oh, I see.

So you’re not overspending your account.

OK. So, in general though, just to wrap it up simply, what you are saying is that you have really have an amount that you’re willing to lose in your mind.

Predetermined.

Predetermined. And you really have to stick with that, right? You can’t really just say, "Oh, let me ride this a little longer."

Let’s say, putting that aside, in general, you have to limit your losses, right? Because sometimes you’re going to be right and sometimes you’re going to be wrong.

Yes, that’s exactly what you have to do, and that’s the challenge that most people have. And in not knowing how to manage losses or even how to size the position properly, you’re subjecting yourself to what could be a catastrophic loss to your account.

Because, remember, it only takes one bad position to lose what you have in that account. And again, some people say, I could buy 10,000 shares, but you lose $2 on that 10,000 shares and now you’re losing more than 1% of your account.

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