What Is the 2% Rule?
The 2% rule is an investing strategy where an investor risks no more than 2% of their available capital on any single trade. To implement the 2% rule,theinvestor first must calculate what 2% of their available trading capital is: this is referred to as the capital at risk (CaR). Brokerage fees for buying and selling shares should be factored into the calculation in order to determine the maximum permissible amount of capital to risk. The maximum permissible risk is then divided by the stop-loss amount to determine the number of shares that can be purchased.
Key Takeaways
- The 2% rule is an investing strategy where an investor risks no more than 2% of their available capital on any single trade.
- To apply the 2% rule, an investor must first determine their available capital, taking into account any future fees or commissions that may arise from trading.
- Stop-loss orders can be implemented to maintain the 2% rule risk threshold as market conditions change.
How the 2% Rule Works
The 2% rule is a restriction that investors impose on their trading activities in order to stay within specified risk management parameters. For example, an investor who uses the 2% rule and has a $100,000 trading account, risks no more than $2,000–or 2% of the value of the account–on a particular investment. By knowing what percentage of investment capital may be risked, the investor can workbackward to determine the total number of shares topurchase. The investorcan also use stop-loss orders to limit downside risk.
In the event that market conditions change, an investor may implement a stop order to limit their downside exposure to a loss that only represents 2% of their total trading capital. Even if a trader experiences ten consecutive losses, using this investment strategy, theywill only draw their account down by 20%. The 2% rule can be used in combination with other risk management strategies to help preserve a trader’s capital. For instance, an investor may stop trading for the month if the maximum permissible amount of capital they are willing to risk has been met.
Using the 2% Rule With a Stop Loss Order
Suppose that a trader has a $50,000 trading account and wants to trade Apple, Inc. (AAPL). Using the 2% rule, the trader can risk $1,000 of capital ($50,000 x 0.02%). If AAPL is trading at $170 and the trader wants to use a $15 stop loss, they can buy 67 shares ($1,000 / $15).If there is a $25 round-turn commission charge, the trader can buy 65 shares ($975 / $15).
In practice, traders must also consider slippage costs and gap risk. These can result in events that make the potential for loss significantly greater than 2%. For instance, if the trader held the AAPL position overnight and it opened at $140 the following day after an earnings announcement, this would result in a 4% loss ($1,000 / $30).
The 2% rule is an investing strategy technique. It is not a requirement by any investing regulatory body.
Advantages of the 2% Rule
The 2% rule’s main advantage is that it helps mitigate risk and preserve capital. By limiting the exposure of each trade or investment to 2% of the portfolio, investors can spread their risk across multiple positions. This somewhat helps force an investor into diversification which can help cushion the impact of losses from any single investment, reducing the overall volatility of the portfolio.
Secondly, following the 2% rule encourages disciplined decision-making and prevents impulsive trading behavior. Emotions such as fear and greed can often cloud judgment and lead to bad investment decisions. By setting a strict limit on position sizes, investors are forced to carefully evaluate each potential trade and consider its risk-reward profile.
On a similar note, the 2% rule also promotes consistency in investing. For investors trying to save money in the long term or trying to put capital towards their retirement, consistency in following the rule can lead to steady, incremental growth over time, rather than exposing the portfolio to unnecessary risks in pursuit of quick gains. Note that the 2% rule does not guarantee positive returns, and investors can still lose money even when following the 2% rule.
Limitations of the 2% Rule
One of the primary drawbacks of the 2% rule is that it inherently caps the potential gains from any single investment. By restricting the size of each position, investors may miss out on opportunities to allocate more capital to high-conviction trades or investments that have the potential for significant returns. This conservative approach may lead to underperformance relative to more aggressive strategies, a sacrifice an investor must decide between when weighing future risk and future returns.
Adhering strictly to the 2% rule can limit investors' flexibility in adjusting their portfolio allocations in response to changing market conditions or new investment opportunities. For instance, if an investor identifies a particularly compelling investment opportunity that warrants a larger allocation than 2%, they may be constrained by the rule and unable to capitalize on it fully. In some ways, this may be psychologically challenging as it may be less fun to adhere to restrictions that limit what you can invest in.
Implementing the 2% rule across a diversified portfolio may result in increased transaction costs, particularly for smaller accounts. If investors are frequently buying and selling small positions to adhere to the rule, they may incur higher brokerage fees, commissions, and other transaction expenses. This can be especially true the more active an investor is.
Maintaining strict adherence to the 2% rule also requires ongoing monitoring and rebalancing of the portfolio, especially as its value fluctuates over time. This can add complexity and administrative burden for investors, particularly those with larger and more diverse portfolios. Moreover, accurately calculating the appropriate position size for each trade or investment to ensure compliance with the rule may require sophisticated tools that may not be accessible or interesting to all investors.
Consider implementing a similar rule but at a different percentage. If holding 50 different types of securities feels overwhelming, consider holding 20 different types, each capped at 5%.
Alternatives to the 2% Rule
There are several alternatives to the 2% rule in investing, each with its own set of advantages and considerations. Some other options may include:
- Fixed Dollar Amount: Instead of allocating a percentage of their portfolio to each trade or investment, investors can choose to allocate a fixed dollar amount. This approach allows investors to maintain consistency in position sizing regardless of fluctuations in portfolio value. This method may become outdated as one’s portfolio grows.
- Risk-Based Position Sizing: Another alternative is to employ a risk-based position sizing strategy, where the size of each position is determined based on the perceived risk of the investment. This approach involves assessing the risk-reward profile of each trade or investment and allocating capital accordingly. Under this method, an investor may come up with a level of risk on their own without using metrics (talked about under the bullet below).
- Volatility-Based Position Sizing: Volatility-based position sizing adjusts the size of each position based on the volatility of the underlying asset. Investments with higher volatility may require smaller position sizes to account for the increased risk of price fluctuations. Compared to the method above, volatility-based positioning may rely on calculations such as beta or standard deviation from the market return to decide what to cap each investment at.
Example of the 2% Rule
Consider an investor who has a diversified portfolio consisting of stocks, bonds, and real estate investment trusts (REITs). She diligently follows the 2% rule when making investment decisions, allocating no more than 2% of her portfolio's total value to any single trade or investment. With her portfolio currently valued at $100,000, she determines that she can allocate a maximum of $2,000 (2% of $100,000) to any given stock.
After purchasing the stock, she regularly monitors the performance of Tech Innovations Inc. and the overall market. If the stock appreciates significantly and surpasses her initial 2% allocation, she may consider rebalancing her portfolio by selling a portion of her holdings. For example, if the stock price increases 10%, the value of her holdings is now $2,200. However, her portfolio is now valued at $100,200. She should now technically hold no more than $2,004 of any given security. By selling $196 of stock and acquiring a different security, she will be back in balance.
To further complicate the example, note that this investor should be mindful to re-invest what she sells, otherwise she won’t be compliant to the 2% rule anymore. For instance, if she sells $196 and doesn’t re-invest it, the total portfolio is no longer $100,200 but instead $100,004. This, once again, changes the 2% allocation. This highlights the complexity to what otherwise appears to be a simple investment technique.
What Is the 2% Rule in Investing?
The 2% rule is a risk management principle that advises investors to limit the amount of capital they risk on any single trade or investment to no more than 2% of their total trading capital. This means that if a trade goes against them, the maximum loss incurred would be 2% of their total trading capital.
What Are the Key Principles Behind the 2% Rule?
The key principles underlying the 2% rule include prudent risk management, capital preservation, and the recognition that losses are an inevitable part of trading. By limiting the size of individual losses, investors can protect their overall capital base and avoid significant drawdowns that may hinder their ability to recover.
What Types of Investments Does the 2% Rule Typically Apply to?
The 2% rule can apply to various types of investments, including stocks, bonds, options, futures, forex, and commodities. It is a universal principle that can be adapted to suit the risk profile and trading style of different investors.
Are There Any Exceptions to the 2% Rule?
While the 2% rule is a general guideline for risk management, there may be exceptions depending on the specific circ*mstances of each trade or investment. For example, investors may choose to adjust their risk exposure based on market volatility, liquidity, or the potential for outsized returns. The 2% rule can be overridden by an investor at any time as it is simply an investment strategy.
The Bottom Line
The 2% rule in investing suggests that you should never risk more than 2% of your capital on any single trade or investment. This approach helps manage risk by limiting potential losses and preserving capital for future opportunities.
