When you start to invest your money, it’s difficult to determine how you should design your portfolio. Which stocks are worth the risk and which aren’t? You will often hear financial advisors say that you should have a diverse portfolio and shouldn’t put too much money into one stock position or investment. 

While this is true in most cases, you might be wondering whether there are instances where it’s a good idea to take a risk and put a large amount of money into a single investment or stock. This article is intended to help you understand how much risk you should take on a single investment and will also cover the topic of sector exposure. Keep reading to learn more.

How Much Risk Is Too Much Risk?

If you aren’t a well-seasoned investor or financial expert, you’ve likely had questions about how much money you should put on the line on a given investment. Of course, it’s difficult to give a particular number, as it all depends on your account size; however, typically, you should not risk more than 1% to 2% of your account on one single trade. 

Let’s look at one example. Say you have $10,000 in your account; you can risk losing $100 in one trade as that leaves you with enough capital in the bank. However, if you have $10,000 and spend $9,000 buying multiple shares of one single stock (with no leverage), you will have used up most of your purchasing power. This is just a simple example to show that your purchasing power is just that—your power. You don’t want to risk it all on a single investment.

This “rule” isn’t necessarily about the amount of money you’re willing to put into an investment, but rather the amount of money you’re willing to lose. In other words, if you’re following the one percent rule and you have an account of $10,000, you can spend much more than $100 on a single investment as long as your maximum expected loss is $100 or less. Of course, this isn’t a guideline to be followed by all investors. Some strategies are different than others, and many full-time traders may use a significant amount of their capital on a trade.

What Is Position Sizing?

Position sizing is a term used to explain how much a single position takes within a portfolio or the number of dollars an investor will put forward in a particular trade. When determining the position sizing, the size of the investor’s account and his or her risk tolerance have to be considered. All investors use position sizing as it helps them figure out how much of one security they can buy, so they can maximize returns and minimize risk. Typically, position sizing is mainly used in currency and day trading. However, it’s a concept in every investment type.

In order to determine position sizing, three main factors need to be considered. They include: 

  • Account Risk: Every investor needs to determine the account risk before deciding the position sizing. Most retail investors and fund managers typically don’t risk more than 1% of their capital.
  • Trade Risk: After the account risk, investors have to figure out where to place their stop-loss order. For example, if you’re trading stocks, the trade risk is the difference between the entry and stop-loss prices. So, if you buy stocks for $160 and place a stop-loss order at $120, then the trade risk is $40. 
  • Position Size: Assume the investor knows that they can risk $100 per trade and is risking $40 with every share they buy. With this information, the position size can be determined by dividing the account risk ($100) by the trade risk ($40).  

Sector Exposure Explained

Sector exposure, or market exposure, is a term used to explain how much money or what percentage of a particular portfolio is invested into a specific industry, market sector, or asset. Market exposure is typically represented as a percentage of the total holdings in a portfolio. For example, that can be a 10% investment into the oil and gas sector or a 20% investment in Apple stocks. 

Sector exposure shows how much an investor can lose from the risk they’ve taken with a particular investment in a given sector. When analyzing an investment portfolio, market exposure is used as a tool that can help balance the risk. If it’s determined that there’s too much put on the line in one particular sector, then that can be an indication that the portfolio needs to be further diversified. 

Risk Tolerance Varies Between Investors and Strategies

When we talk about risk tolerance, we’re typically discussing how much risk an investor is willing to take, given how volatile the value of a certain investment is. In most cases, risk tolerance helps a person determine what kind of portfolio they’re going to have and what kind of investments will be present in it. 

Generally speaking, when an investor is willing to take a greater risk, they typically invest in stocks, ETFs (exchange-traded funds), and equity. On the other hand, having lower risk tolerance often means putting money into bonds, income funds, and bond funds. 

An In-Depth Look into Risk Tolerance 

When you begin to invest, taking a risk is a given. You cannot participate in the stock market if you’re unwilling to take any risk at all. With that said, your degree of risk tolerance is what will help you determine what kind of portfolio to design and what investment strategy to follow. Based on their risk tolerance, investors are put into one of three categories: conservative, moderate, and aggressive. 

One major factor that is typically used to determine risk tolerance is how long an investor is willing to wait before wanting to get the return on their investment. If an investor has a far-away horizon, they may have great success by carefully putting money into higher-risk assets such as stocks. On the other hand, if the time horizon is shorter, then lower-risk investments may be better. 

Other factors that can help determine risk tolerance include future earning capacity and having other assets such as a home, social security, or a large inheritance. If a person has more stable sources of funds, they will be more willing to take a greater risk when investing in the market. Additionally, investors with a large portfolio are more tolerant to risk, compared to those with a smaller portfolio, as the percentage of loss is a lot lower.

Aggressive Risk Tolerance

An investor with a high-risk tolerance (aggressive) will be willing to lose more money if there’s a chance of getting better returns in the end. Such investors tend to have a great understanding of the volatility of the market and follow particular strategies that enable them to get higher returns. This investment strategy typically consists of putting capital mainly in stocks, with little to no allocation to cash or bonds. 

Moderate Risk Tolerance

Moderate risk investors are the kind of people that want the best of both worlds. They want to earn more from the market without risking too much. Their investment strategy relies on proper research and in-depth consideration of the risks they will be taking with their portfolio. Moderate investors are considered to be “balanced” players on the market, and their portfolio is a mix of stocks and bonds, generally opting for a 50/50 or 60/40 structure.

Conservative Risk Tolerance 

These investors are not willing to accept almost any risk within their portfolios. These are typically people who are close to their retirement age or already retired and so are more unwilling to risk a loss, as they don’t have sufficient time to fight for returns at a later stage. Conservative investors have a short-term investment strategy and target liquid and guaranteed interests such as bank certificates of deposit, U.S. Treasury Securities, and money markets. 

In Conclusion

When it comes to investing, your degree of risk tolerance will be crucial in determining the kind of investment strategy you choose to follow and the kind of portfolio you will create. Generally speaking, most financial advisors will tell you that you shouldn’t risk more than 1% to 2% of your capital on a single investment and that a portfolio should be diversified to lead to better returns in the long run.

While this is true, sometimes, you may fall into situations where you’re willing to take greater risk and put more of your money into a single stock or asset. Determining whether you should do that or not isn’t easy and often requires in-depth market knowledge, as well as in-depth research on the performance of the particular investment you want to make. 

In such situations, you may benefit from the help of a financial advisor, such as those at Alpha Wealth Funds. We’re here to help you make decisions about risk tolerance, investments, and anything else regarding growing your personal wealth. Reach out to us today to receive guidance as you continue your investment journey.

Please feel free to reach out to me on this or any of your investment needs or questions. I may not always have the answers at my fingertips, but I promise I will get them for you. Harvey Sax

Founded in 2010, our services include boutique hedge funds, separately managed accounts, financial planning, estate & trust services, private placements, and in-house concierge services for high net worth individuals, families, and businesses.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. All investments involve risk including the loss of principal.