Sep 16, 2022 - Investing    1 Comment

Stock Investing Methodology

My investment methodology for stocks depends upon a couple of things:

  • how much am I willing to lose on the investment
  • what is my level of affinity for either the company or their product
  • what do the fundamentals for the company look like

I use a spreadsheet (insert link) that enforces some basic rules I’ve come to trust about how to calculate position size for each trade I make. This calculation does not inform which stocks I pick (add link to stock picking notes). The formula simply ensures I’m operating within the guardrails I’ve established for where I put my money. This way I ensure I’m deploying money based on it being a math problem, not an emotional decision.

Before I buy I first figure out what has to be true for me to sell the stock, how much volatility in price I will tolerate, and what I will do with the investment while I’m waiting. To understand the formula described below its important to understand some assumptions built into the calculation.

Methodology

First, no more than 10% of my portfolio is ever invested in any one stock. No matter how much I love a stock, I have a hard ceiling. Note: I am currently rebalancing with the goal of bringing this distribution closer to 5% max in any one stock. The market correction of 2022 is the primary driver of this change. For simplicity, what this means is if I am in love with AAPL stock (as I am) and my total portfolio value on the day of the buy is, say, $100,000, I will only ever invest a maximum of $10,000 in Apple’s stock. Total. Ever. Across all my stock accounts. If I already own $5,000 in Apple stock, I’m only allowing myself to buy $5,000 more. This measurement is made at the time of the buy. If the price climbs and the investment grows as a percentage of total portfolio value, I’ll adjust. More on rebalancing later (add link).

I have a maximum risk threshold that represents the total loss on an investment I’m willing to accept. Currently my default is 5% of the amount to be invested. Think of this as a ceiling for loss. For example, if I am investing $10,000 into Apple and my risk threshold is set at 5% I’m telling myself I don’t want to ever lose more than $500 on this investment. Taking this approach also ensures that no one stock will ever tank my portfolio. 5% of 10% ensures I should not ever lose more than 1/2% of my portfolio if a stock suddenly goes south.

Next, for each stock I invest in I assign it a sentiment grade (A-D) that reflects my feelings about the stock. I don’t use robo-traders so I have to acknowledge that my emotions are going to creep into buy/sell decisions and this grade is an up-front assessment of how emotional I may be.

  • “A” grade stocks I feel are low risk, I think the fundamentals are solid (link to stock picking), or I am not emotionally tied to them. I expect them to perform a certain way or have less tolerance for price swings. These are my “boring” stocks. They have fairly tight guardrails and if they miss the mark, I’m out. AAPL (which I love as a company) and OXY (which I don’t) are examples of stocks I’ve graded “A”.
  • “D” grade stocks are those for which I have a strong affinity. Oftentimes my love for them runs counter to the company’s underlying business fundamentals. Analysts may hate them, but I love them. I’m emotionally tied to these stocks. I’m willing to tolerate wild swings in price because I’m a fan – I want to believe! COIN and ROVR are examples.
  • “B” and “C” stocks are simply somewhere between those two extremes.
  • There is no magic formula for assigning these grades. It’s nothing more than a gut feeling.

For each sentiment grade I assign a percentage that represents the price swing tolerance I’ll endure for stocks with that grade. I use this to both set the trailing stop loss order sell price as a percentage of the buy price (or highest price, if price keeps rising after purchase), and to help calculate the maximum number of shares I will purchase. This is all figured out before I purchase the stock. Here’s how I have those defined:

Sentiment GradeSentiment Grade S/L
A8.00%
B12.00%
C15.00%
D20.00%

Important: The sentiment grade percentage can never be lower than the maximum risk threshold I’ve defined above. If it is, the risk threshold is used as the sentiment grade value in the formula below.

Up until recently I had “A” grade stocks set at 5%, but recent wild swings in normally stable stocks caused me to raise this and the “B” percentage slightly.

If my mood about a stock changes, I change the sentiment grade and the formula informs me of changes I need to make to the trailing stop loss order or the number of shares I can own.

Formula

Here is how all of this gets translated into the number of shares to purchase using my Apple example from above:

Assume I have $10,000 to invest (max), with a risk threshold (risk) of 5%, and that today’s stock price (price) is $150:

  • The “A” sentiment grade (grade) = 8%
  • Sell price: sell = price * (1-grade)
  • Price difference: delta = price - sell
  • Shares to purchase: shares = (max * risk) / delta

Using actual numbers:
42 = ($10,000 * 0.05) / ($150 - ($150 * (1 - 0.08)))

Given the math, I can purchase up to 42 shares (or $6,2500 worth) of Apple. Immediately after purchasing I set a trailing stop loss order for 8%. If the stock price drops by 8% or more the sell trade executes immediately and I’ve lost no more than $500. If the price rises, then the trailing stop loss price rises with it, always being set at 8% below the highest price. Doing this has the added benefit of capturing gains if the stock rises for a while but then suddenly shifts direction. Like we’ve seen happen recently 🙂

Next I’ll share how I pick stocks.



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