Tuesday, August 29th, 2006
Six weeks to a full trading risk/money management plan
There is really only one cast-iron rule in trading and investing: don’t lose all your money. Or to put it another way: stay in the game at all costs and don’t blow up!
In the next few weeks I’ll show you how to develop a full risk/money management plan for an active trading/investing strategy. (Note I’ll use the terms risk management and money management interchangeably).
Risk management is a frustrating area for new and even experienced investors because there is so little information available about it.
There is some great literature on the topic, mostly from Van Tharp. But even then there are some practical issues that I’ve had to work out the hard way. This guide aims to provide a bit of a short cut for you and hopefully help you avoid some of the frustrations I experienced.
The first article will outline the two basic principles that need to be embedded in your investing psyche before you get into the nuts and bolts of building a risk management system.
Subsequent articles will deal with:
1. How much to risk per trade
2. How much of your total account to risk
3. Account diversification
4. How to increase risk fearlessly
5. A summary of risk management resources
There are two beliefs that form the basis of risk management:
1. THE WORST POSSIBLE OUTCOMES ABSOLUTLEY DO HAPPEN
When reading about legendary investors most of their stories have a common thread: they got into the market, had some initial success, then blew their account up! After that they learnt the importance of controlling risk.
Therefore, it is easy to think that to become a successful trader you have to lose most of your money. One part of me thinks this is true. Why? Because most people think they’re different. Most people know there are risks in the market but deep down honestly believe that they will escape the worst of them. Perhaps the only way to grasp the fact that no one is immune to market risk is to actually lose everything.
From my own perspective I am yet to blow up (and hopefully won’t) but I grew up in a family that owned a variety of businesses and saw first hand that EVERYTHING can and DOES go wrong sometimes. That is, the absolute worst scenario that you think is virtually impossible does happen, often when you’re least expecting it and at the height of your success. Markets crash, interest rates go to 20 per cent, inflation spirals out of control, terrorist attacks occur.
If you don’t grasp this concept then perhaps you will only learn it by losing all your money. Of course that doesn’t have to occur if you take the concept seriously.
2. WE CAN’T PREDICT THE FUTURE
If you haven’t, and don’t want to, blow your account up and lose everything, then one of the best ways to get in the right frame of mind is to accept that we can’t predict the future. Or as Mark Douglas puts it in 
Trading in the Zone, it’s about recognizing “the market can do virtually anything at any time.”
Douglas has a great explanation of this. He says the market is simply a bunch of people making decisions. To accurately predict the future you need know how every single one of these people will act. That’s because just one person can ruin your edge.
This has happened to me many times. I’ve been dead certain that a stock will go higher and the market has been surging ahead taking everything with it. There was no explanation for why the stock shouldn’t rise. But out there somewhere was a fund manager who for some reason, perhaps repositioning their portfolio, was dumping the stock. So in a raging bull market the stock fell. I only found out later, when a substantial shareholder notice was released, who the big seller was. There is no way in the world I could have known that fund manager was going to offload his holding in the stock that day.
When you acknowledge that in reality you actually don’t know where a stock is heading, then it changes your whole attitude to risk. People take huge risks when they are certain of an outcome. ‘This stock has to crash so I’ll take a huge short position’, ‘This stock will absolutely double so I’ll buy it on margin.’ But if you’re not absolutely certain of an outcome why would you put your whole account at risk? You wouldn’t, you’d be thinking, ‘I could actually be wrong so I better take protective measures in case I am.’
That said, believing we can’t predict the future doesn’t mean we don’t try and analyse the market. We do. But as Douglas says, our analysis will merely give us an edge that “is nothing more than an indication of a higher probability of one thing happening over another.” You should start staying ‘this stock will probably rise, but I’m not certain’.
The key to risk management is accepting the worst possible scenario can and will sometimes happen and that we can’t predict the future. You then design a system around these beliefs, which we’ll do in coming weeks.
Word Count: 845. This entry was posted on Tuesday, August 29th, 2006 at 9:27 pm and is filed under Risk management. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
