A common question vexing many small investors is how many shares of each company to buy. A young investor friend did quite a detailed analysis of a particular company, and took some inputs from me to fine-tune his analysis process.
After a few iterations to arrive at a proper valuation, he decided that the current price had enough ‘Margin of Safety’ and decided to buy the shares of the company. How many shares did he buy? 100. Nothing wrong with that. Small investors can’t always spare a lot of cash.
What happened next? Within a short time, the stock spurted on large volumes and doubled in price. My friend was left ruing the fact that he didn’t buy more shares even though he had spare cash. Shortly thereafter, the company announced a bonus issue, and the stock spurted even higher.
In spite of doing due diligence, a big money-making opportunity was lost because a sufficient quantity of shares were not purchased to start with. Such opportunities don’t come often. So, how do you decide what is a ‘sufficient quantity’?
In last Tueday’s post: How many stocks should I buy?, I had outlined how a Rs 5 lakh portfolio can be allocated to large caps, mid caps and small caps. The suggestion was: 8 large caps worth Rs 50,000 each, plus two mid caps and two small caps worth Rs 25,000 each.
While the money allocation to each category of stocks would automatically limit how many shares of each company you can buy, it won’t eliminate the risk factor. Different investors have different risk tolerance levels, and that should be built into the allocation.
Here is a simple example. Suppose you decide that the maximum loss you can afford in the large cap stocks is 5%, and 10% in the mid and small cap stocks. Your large cap allocation is Rs 50,000 to each of 8 companies. Your mid and small cap allocation is Rs 25,000 to each of 4 companies. A 5% loss in the large caps and a 10% loss in the mid and small caps would limit the loss to Rs 2500 per stock.
(If all your picks fail to perform and hit the respective stop-loss levels, your total loss will be limited to Rs 30,000; i.e. 6% of your Rs 5 Lakh portfolio.)
If you decide to buy a large cap with a current price of Rs 100, you can buy 500 shares with a Rs 5 stop-loss to ensure that you limit your loss to Rs 2500. What if a mid cap is trading at Rs 100? Should you buy 500 shares in that case?
Since mid caps tend to fluctuate more, you had chosen a 10% loss as your limit. That would mean buying a Rs 100 stock with a Rs 10 stop-loss. Buying 500 shares may incur a loss of Rs 5000 if your stop-loss is hit. So, you need to buy only 250 shares with a Rs 10 stop-loss.
The example is simplistic to make a point. You need to adjust stop-loss levels for each stock that you buy according to your comfort level and the beta value (i.e. the amount by which a stock fluctuates with respect to an index) of each stock.
