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The financial markets have been challenging recently, to say the least. Strategies that worked in the first part of the year had little impact weeks later. Still other segments of the market have experienced tough sledding for a year or longer.

In summary, it’s been hard to gain traction with any of your investments.

But as investors, we must play the hand we’re dealt. And right now that hand is one that offers short-term (and oftentimes fleeting) gains. Put another way, there are small pockets or sectors where strategies are working, but the time horizon requires a slight adjustment. One can no longer focus on the intermediate or long term, rather one must focus on shorter term trading moves to increase returns.

An important component of any successful portfolio has always been what’s termed as “position sizing,” a crucial element in today’s investment environment. Position sizing is key once you decide to buy a stock or ETF, because it helps you establish three control parameters with your investment: Entry Price, Position Size and a Logical Point to Exit if the trade goes against you.

Does position sizing really matter? It absolutely does.

Without properly determining these key parameters upfront, you have no way of minimizing position risk while maximizing the account value.

In this article we’ll discuss a concept called the Percent Risk Method, which is my preferred approach for deciding how much to invest in each security position. Over more than 25 years of advising, I’ve found that this strategy works very well for trading accounts and longer-term investment accounts.

The Percent Risk Method

First, we’ll take a look at just the positions which fit our risk-based criteria using Point and Figure charting.

Let’s say you have a $500,000 investment or retirement account. Depending on the type of market we’re currently in, we would choose position sizes ranging from one-half percent to two percent of your total portfolio value.

As an example, let’s say we agree to use a one percent risk tolerance per position in your account. This means that each position will be sized so that the risk to your overall portfolio is no more than one percent of your $500,000 account, or $5,000. So, that $5,000 becomes our risk for the first position.

So let’s now approach that single position based on our calculated risk. In this example we will use our old favorite XYZ stock. Since we know (or can determine) the stop-loss point for our trade in stock XYZ, we would determine the distance from our entry point to our stop-loss point (risk to stop), and then divide that into our $5,000 risk for the position. The resulting value will be the number of shares that we can purchase to stay within our one percent risk tolerance.

So if our XYZ stock is trading at $49 on its trend chart, and we’ve determined that this is a reasonable investment to consider, we have a pattern that would suggest exiting at $45. Our entry price would be $49, and our risk on this trade is $4 ($49-$45) or our stop.

We now divide our $5,000 risk for this position by our $4 risk per share, which gives us a position size of 1,250 shares. So if we buy 1,250 shares of XYZ stock, and get stopped out with a $4 loss, you would lose $5,000 — which was the original risk tolerance in the first place.

Naturally, as the distance to your stop-loss point decreases, your share size will increase. Conversely, the opposite will occur when you’re considering stocks trading further from your stop point — the number of shares purchased decreases.

So, with the percent risk model that we used, the most that is ever risked per trade is one percent of the account value at the time the trade is made. (It’s good to note the account in order to market each day before you can figure out what the one percent risk would be for any subsequent trades.) The main rule to follow in this method is that you must respect your stop points. Remember, your position is sized as a function of the risk to the stop point. So if your stop point is hit, you must stop out, or obviously you’ll risk more that the previously determined one percent loss.

The real beauty of the percent risk method of position sizing is how much it can enhance your returns. If you have a large position in an individual security (and therefore the stop point is tight), and that trade works out in your favor, you’ll add considerable money to the bottom line vis-à-vis a smaller position, all while risking the same as any other trade.

Another fundamental benefit of this approach is that it helps us deal with the emotional end of investing. The Percent Risk Method takes some of the emotional influence out of the process by forcing you to make smaller “bets” when the market dictates, and forcing you to make sequentially equivalent bets on each trade. When the market is on offense, we would typically suggest taking a one percent position in every trade, regardless of how bullish your emotions dictate any single trade. This keeps any single position from beating you, and allows for the trading system to work based upon its own merit.

Finally, the often difficult and emotionally trying decision of when to sell has been pre-determined when you initially enter the trade. The key, though, is to adhere to your pre-determined stop.