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Why is money management one of the first items that professional traders stress? Why would you think? Here's an overview of risk and several simple mechanical approaches to money management.
Preserving capital is essential to a trader's long-term survival. The only legitimate objective of trading or investing is to make money; if you trade for the thrill of it, you are playing the world's most expensive sport. The objective of any money management system is simple: If followed, it will force you to cut losses short and let profits run. Most novice traders - and the bulk of today's mutual fund investors - approach any decision with one question on their minds: What is my expected gain? They fail to ask a question that is far more important but is often overlooked: What is my potential loss? If your potential loss on a trade equals half your capital, two bad consecutive trades will wipe you out. If given the choice between avoiding a loss or participating fully in a gain, our first impulse is often to choose the latter over the former. But is that the better choice? Avoiding losses is far more important to long-term performance than making big profits because of two basic mathematical principles:1 The more your account or portfolio grows, the greater dollar impact a given percentage decline will have on your equity.Say you begin with a $100,000 account and for three years in a row, you score solid back-to-back gains of 20% per year. At the end of that period, your account has swollen to about $172,800. If, however, in the fourth year, you suffer a 45% loss, your account will plummet to below the level where it began - $95,040. This doesn't seem fair, since the arithmetic total of your gains (3 x 20% = 60%) exceeds the 45% loss, but the 45% is being applied to a much larger number, so three years of gains are erased. A 45% loss may sound excessive to an equity trader used to a market that hasn't corrected more than 10% in seven years, but he or she needs only look back to 1973-74 to find a 44% correction in the Standard & Poor's 500 index. Many growth mutual funds and the Nifty 50 stocks suffered 70-80% losses. Other sobering observations: It takes a 100% gain to make up for a 50% loss and a 49% gain to break even after a 33% loss. An aggressive trading plan that generates spectacular returns but has no money management or risk control plan is doomed to failure.2 It takes a far greater percentage gain to make up for a given percentage loss.
NO FEAR
When a computer scans your charts or tests a system, it experiences no fear or greed. It makes no exceptions. It simply executes orders, mindlessly and mechanically. If most traders could perform in such an unemotional and mechanical fashion, their performance would be far superior to their real-world results. When developing a trading system, it is crucial first to study your own emotional makeup; it takes a certain intestinal fortitude to daytrade the S&P 500, just as it takes another type of courage to hold a basket of growth stocks for months or years through pullbacks or corrections. Most canned systems fail because a crucial ingredient is ignored - matching system characteristics to individual psychology.If you do not have a risk control plan, get one - in writing. Promise yourself never to enter another trade without knowing exactly when you will exit.