How should we buy? – Allocating capital

There are various ways to allocate capital to a portfolio and everyone seems to have their own method. There’s probably only a few ways to get this wrong. But, many ways to get this right.

Today’s article will be more about allocating capital for your active portfolio, i.e, the portfolio that you trade with.

This is not long-term capital management (no pun intended!). I’m happy to do a separate article on full portfolio allocation the way we were taught during the CFA and the way I’ve personally done it in practice. That’s more based on your life circumstances and I could help you with a framework to consider your needs.

Active Portfolio Management

I would imagine that the majority of community here actively trades their portfolio – primarily led by day-trading. But, I would also imagine that it could be rewarding to slow things down and take positions that run from a few weeks to a few months, the way Mayhem and I have been looking at stocks.

So the first thing I would say is to make sure you divide your portfolio accordingly. If you want to day trade, allocate 60% of your active portfolio there and the rest to longer term trades. You could do the opposite, if you think swing is more your cup of tea or coffee, as the case may be.

Allocation to Swing Trades

Now that you have your swing trading portfolio allocation, you can decide again how much you want to allocate by timeframe. But, the better to do it would be by risk metric.

Say you have $1000 dollars for swing trading:

• 20% or $200 in the riskiest trades (gambles)

• 30% or $300 in medium risk trades

• 50% or $500 in lower risk trades

It’s not always easy to determine what’s high risk and what’s low risk. We will try to mention the risk levels based on the fundamentals as we go put out ideas but some of it also subjective i.e., depends on how you see the trade. We would definitely like you to form an opinion based on what we write.

One way to think about it is through timeframes. If a trade is short term within 3 weeks or earnings related, these would be risky trades. Something you would hold fore 3 months or so would be medium risk and up to a year or two years would be lower risk trades.

Why timeframes? Because if the trade goes against you, you have time to recover. That time to recover makes the level of risk more or less acceptable.

Position Building

Finally, let’s talk about position building. The table below is how I try to think about it. I am more risk averse than most people I know. So, this is by no means a set rule and you can change up the allocations as you wish in between but the two items that I would request you to consider are the starting size and the pullback adds.

The riskiest trades should have the smallest starter and pullback adds. Quite often I will take 10% in a company while I am doing my due diligence and then add or dump after I’ve come to a conclusion.

But the basic ideas is not to put to much of your capital at risk.

Everything in this article has discussed buying. However, this applies to taking shorts as well. Although, I’d be far more cautious while taking short positions and treat them all as High Risk or Medium Risk.

Taking Profits

I’m sure you’ve heard the adage – “take profits early and often”. I’d add to that – “and don’t look back”.

The FOMO culture has left us in a bad mess. Let’s put a stop to it. It’s never to late and there’s always another trade around the corner.

I like to take my profits early. My worst mistakes in swing or any kind of short-term trading was holding on for too long. I was being silly and greedy.

We try to give out tentative targets with our ideas but, I would say take profits when you feel comfortable. If you think a 5% gain is good, take 25% off or even 50% off the trade.

I like to take profits more aggressively on riskier trades so I’d probably reverse the table above, i.e., I would use the high-risk allocation method to take profits in the low risk trades and vice versa. So, for example, I would start taking profits in a high-risk trade by taking 30% off the trade.

Final Thoughts

Much of what I have discussed above is how I like to take positions. It’s worked for me and I think my approach is cautious but not extreme so we don’t make money. I do however, always approach things more from the perspective of protecting my capital i.e., how much I don’t want to lose instead of thinking how much I can gain. Being a corporate banker has left me with loss aversion in my blood!

Stay sharp and be careful out there.