When meticulous research and consideration has led you to pick a stock to buy, how should you go about investing in it? Carefully crafting your approach to adding shares of any given stock can work wonders to bolster your portfolio's overall returns.
Because there are different ways to do this depending on the company in question, several factors need to be considered. In this article, we will explore how to approach building a new investment in two very different companies, using Boeing (BA 0.97%) and Tesla (TSLA -0.52%) as juxtaposed examples.
Building equity exposure
First, it's important to preset the amount of exposure you want to have in a stock. This works better when determining the desired position size based on a percentage of your portfolio rather than a specific dollar amount. Incremental additions to or subtractions from account balances should not drastically impact your approach to a stock purchase. Choosing your positions based on percentages helps ensure that they won't.
The actual size of an investment depends on a person's investing philosophy. Generally speaking, 5% of a portfolio allocated to a specific stock is about as large as anyone should start off with. If the stock is more risky and volatile -- like with Tesla -- less initial exposure may be warranted.
Once you determine how much of a stock you want, then it's time to decide what portion of your desired exposure to purchase initially. It's never a good idea to buy your entire stake in a stock all at once.
Iconic investor Warren Buffett frequently refers to the stock market as "Mr. Market" due to its apparent irrationality and emotional nature. Investing in a company all at once means you're fully exposed to whichever emotion Mr. Market is feeling on the day you buy. By spacing out those purchases, investors have a much better chance at mitigating the potentially damaging spontaneity of Mr. Market. It requires a bit of discipline, but this is investing, not gambling.
For example, say you decide to invest 40% of your overall desired exposure in Boeing in your first purchase. This leaves 60% to invest later at your discretion and/or when it might benefit you most. As markets become more turbulent, chances to add to quality names at lower prices often will present themselves.
After the opening purchase, investors using this approach will often increase their exposure in small pieces on 10% to 20% price pull-backs until their position is full. If no pullback comes (there have been several such events for both Tesla and Boeing), there are worse problems than making less money than you otherwise would have.
By choosing to build up your positions over time, you give yourself the chance to lower your cost basis when opportunities surface. This concept is referred to as "dollar-cost averaging" and is an effective, responsible way to add funds into your favorite names.
There is not a one-size-fits-all schedule for when and how to add to a stock position. Instead, each company's specific circumstances should be considered when crafting an investment approach. Let's look at two examples.
Why Boeing and Tesla require different strategies for investors
First, let's consider Boeing. The aerospace powerhouse has been beset by a years-long deluge of bad news, but let's say you've decided all those negatives have been appropriately priced into the stock, and you are ready to open a position. With the stock trading 63% below its all-time highs, you could choose to be more aggressive on your opening purchase -- instead of deploying 40% of the money you've decided to allocate to Boeing on day 1, you could invest 60%.
For Boeing, a couple of tough years have lowered shareholder expectations considerably, meaning it will take a whole lot more incremental bad news to send the stock down even further. You still don't want to invest all at once -- there's always the possibility things could get even worse for the troubled manufacturer -- but you can be more assertive in starting your position.
Then there's Tesla, shares of which have shot 670% higher over the past 12 months. The electric vehicle company now trades for a lofty price-to-earnings ratio of 923. This sky-high valuation means that the market has priced in some extraordinary growth potential for this company.
Does this mean that investors passionate about the idea of buying a piece of Tesla should wait until the price pulls back to open a position? Not necessarily.
However, it does mean that it makes sense to start smaller with your opening purchase. This way, you have room to buy more shares if the news for the company turns sour and its stock price finally takes a breather. Although it's somewhat unlikely, Tesla stock could continue rapidly rising for the foreseeable future. It could also drop 21% in a single day like it did earlier this week. Starting out with a small piece instead of nothing will allow you to profit from those gains if they come, while still leaving you with plenty of funds to dollar-cost average in.
Don't do it all in one day
Building equity exposure in a stock should take patience and time. While it's sometimes tempting to jump in all at once when excitement about a stock takes over, it's best to ignore those urges. Rome was not built in a day, and your stock positions shouldn't be either.