How To Size Exposure As An Active Investor

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Summary

Understand your exposure and how it relates to your own personality and ability to absorb amplitude in your account.

Incorporate your exposure rules as a component to an overall investing or trading plan.

Recognize both sides of the equation when using leverage, and decide ahead of time how you will react when things don’t go your way.

This idea was discussed in more depth with members of my private investing community, The Active Investor. Start your free trial today »

Most of the articles I write relate to the overall markets, and our expectations for certain instruments and their price targets. In this article, I want to discuss a few approaches that might help investors maximize performance and minimize risk when taking advantage of investment opportunities.

A common question I get from investors and traders is how to determine the correct size of exposure to allocate to each investment opportunity. The simple answer is “it depends”. It depends on a number of factors, as there is not a “right size fits all” when it comes to appropriate exposure. As an example, it depends on the risk to reward skew of the particular opportunity, your individual risk tolerance, whether you are using funds in a 401K vs. a self-directed IRA account, your tolerance for the overall amplitude in the value of the capital accounts you are managing, or whether you are using leverage, just to name a few.

So, let’s take several different scenarios and consider how you might go about determining what your correct exposure should be. Remember, having an individual plan that suits your own needs and personality is imperative. Size of exposure to each opportunity is one component to your overall plan.


 

401K

As an example, if you are exposing capital from within a retirement account like a 401K, then the question of exposure size is significantly different than managing capital from within a self-directed IRA or individual brokerage account. Typically, the only question relating to investment exposure in a 401K is when to be in a “risk on” posture versus when to be neutral and in cash. As equity markets ebb and flow, exposing 401K capital to long exposure in varying sizes makes sense, of course, but you don’t have the choices available with most 401K plans to trade the various sectors that you would in a self-directed account. You are simply 100% long equities, a portion long equity, or 100% in cash. Other choices may include exposure to certain industry sectors and/or foreign market funds. Another alternative available in 401K plans are bond funds and, therefore, you might have a portion of capital long bonds if the correct setup is in play with bonds, but outside of general equity funds, bonds, and cash, your investment choices are limited as going short with the use of inverse ETFs is not a choice. That does not mean that your ability to grow capital rapidly is limited by only being able to be long equities or bonds. By standing aside in equities during meaningful pullbacks and re-entering at areas of key support, you can achieve significantly greater performance over the years than by staying in a constant “risk on” posture. However, in terms of how much you allocate to these or other sector funds available in a 401K, it is markedly different than the options available when managing a self-directed account. As a very general guideline, while managing your funds within a 401K, one approach might be to view three common exposure postures – 1. 100% long equities; 2. 50% long equities; and 3. 100% cash. During times when markets are clearly in the topping region, going to 50% cash makes perfect sense. Then, upon a break of support, exiting the other 50% makes sense. Conversely, when markets are in the bottoming region of support, entering a 50% long position and allowing yourself additional capital to add at the next lower level of support or after the completion and retrace of an upside impulsive move to add the other 50% makes sense.

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