What You Need To Know About Money Management
Money Management: Just Like Sex
So how much thought have you given to
money management recently? Or are you still too preoccupied by all
kinds of indicators or CNBC fundamental buy, sell and holds to focus on the
subject? Eventually, however, you’ve got to ask yourself the most important
question of all: “how much?” right? Getting a straight answer to that one may be
tough. There’s still a lot of confusion about risk or money management from
so-called gurus. I recently saw the following comment regarding money management
from a “guru”: “(We) use very simple money management: Trade one contract per
trading signal in the markets … with no pyramiding.
“This is NOT money management. When you hear someone
describe money management like this trading guru, run don’t walk the other
direction as you are about to be conned. So if money management isn’t some set
amount of shares or contracts picked out of thin air, what is it? Money
management answers the question of “how much?” At all times, given the risk you
are taking, the money you have, and the volatility of the market — you must
know the optimal number of shares or contracts to be long or short. In my
opinion money management or position sizing or bet sizing just doesn’t get the
attention it deserves. Gibbons Burke of
www.markethistory.com observes: “Money management is like sex. Everyone
does it one way or another, but not many like to talk about it and some do it
better than others. But there’s a big difference: Sex sites on the Web
proliferate, while sites devoted to the art and science of money management are
somewhat difficult to find.”
Money management is ultimately a defensive concept. It keeps
you in the game. For example, money management tells you whether you have enough
new money to trade additional positions. Trend followers all realize that you
need to make small bets initially to simply stay alive and play another day. So,
if you start at $100,000, and you’re going to risk 2 percent, that will be
$2,000. You say to yourself, “Why am I only risking $2,000. That’s nothing
compared to what I’ve got to bet.” But that’s not the point. First things first.
You can’t predict where the trend is going to go, so you can’t afford to risk
all of your capital out of the gate. Trend follower Craig Pauley points out:
“There are traders who are unwilling to risk more than 1% but I would find it
surprising to hear of any trader who risks more than 5% of assets per trace.
Bear in mind that risking too little doesn’t give the market the opportunity to
allow your profitable trade to occur.”
Think about money management as you would about getting into
physical shape. You can’t lift weights six times a day for hours each day for 30
straight days without hurting yourself. There’s an optimum amount of lifting you
can do per day that gets you ahead without setting you back. You want to be at
that optimal point just as you want to get to an optimal point with money
management. Trend follower, Ed Seykota
www.seykota.com, author of The Trading Tribe book, describes this optimal
point with his concept of “heat”. “Placing a trade with a predetermined
stop-loss point can be compared to placing a bet. The more money risked, the
larger the bet. Conservative betting produces conservative performance, while
bold betting leads to spectacular ruin. A bold trader placing large bets feels
pressure – or heat – from the volatility of the portfolio. A hot portfolio keeps
more at risk than does a cold one. In portfolio management, we call the
distributed bet size the heat of the portfolio.”
Trading correctly is 90% money management, a fact that most
people want to avoid or don’t understand. However once you have money management
down, your personal psychology will be 100% of your trading success. Once you
have the rules, you still need to follow them! Why then do traders have such
trouble keeping their trading proportional? Why is it so hard for them to find
that optimal point? Fear. Trend follower Tom Basso points out that traders
usually begin trading small and then as they get more confident increase their
trading size. Once they get to a certain comfort level of say, 1000 contracts,
they often stay there, suddenly fearful that turning up the “heat”, to use
Seykota’s term, will increase their risk. For trend followers like Basso, the
goal is to keep things on constant leverage. Few traders make the move to a
proactive posture in which risks are actively managed for a more efficient use
of capital.
How do you avoid trading less instead of trading the optimal
amount at whatever capital you have? You need to create an abstract money world.
Don’t think about what money can buy. Just look at the numbers like you would
when playing a board game like monopoly or risk. And since your capital is
always changing, it’s important to continually rebalance your portfolio. Trend
follower Paul Mulvaney points out that, “Trend following is implicitly clear
about dynamic re-balancing which is why I think successful traders appear to be
fearless. Many hedge fund methodologies make risk management a separate
endeavor. In Trend Following it is part of the internal logic of the investment
process.”
There it is: the key is a risk understanding. That’s what
money management is really all about. Managing risk. In “A Perspective on Risk”
Jim Little & Sol Waksman take risk management a step further: “Sound
investment policy is really about intelligent risk management. There is no such
thing as a risk free investment. Even an investment in cash exposes the investor
to the risk that his buying power will erode through inflation. The real issue
is not whether you want to take risk, but which risks and how many of them you
are willing to accept. To make intelligent decisions as to how much of a
particular risk is right for you, and how to blend risks properly to lower
overall portfolio risk, you must have accurate measurements about how much risk
each sector of your portfolio is exposing you to. Some investors rely on
conventional wisdom (or lack thereof) to dictate their asset allocation. Others
rely upon outdated statistics. The wise investor continues to study the facts.”
David Harding
www.wintoncapital.com, the founder and CEO of Winton Capital also makes the
clear case for thinking about risk: “It is a risk management business. An
investor should be hiring us to take risk on their behalf, and we will take
exactly the level of risk that they ask for. For example, if an investor has USD
10 million and asks us to produce annual variance of 1 per cent on that, we will
do it and we will get it exactly right. In contrast, returns are not
predictable!” And there’s the rub for most people and most gurus. Money
management or risk management is all about reality, and most people don’t want
to face something as hard as the real world. They’d rather predict or pretend.
Which do you want to do?
Michael W. Covel is the founder and President of Trend
Followingâ”