Money and Risk Management
Assume you make only 30 trades in an entire year. If you extrapolate this table you will have an annual return on your capital of 27.08%, while never risking more than 3 percent of your available capital in any one position. If you now extrapolate this table in the other extreme, if you lose on 30 consecutive trades (a highly unlikely event) you would still have 40% of your capital available to build with. I understand this is an oversimplified example. It does, however, illustrate the principles of preservation of capital, and steady, consistent performance very well. In the real world, however, you may lose 5 trades in a row, win the next 2, lose money on the next 4, and win 3 of the next 5. If you use this type of money management, however, and are right but 33% of the time, your results will be similar. Take this 3% rule we have created for ourselves one step further. Risking 3% of your trading capital in any single position does not mean that you use all of your capital in one position with a stop loss order 3% below your entry price. Often, in this author's opinion, you must risk more than 3% of your entry price. Depending on market volatility, or the volatility of the issue you are trading, a 3% price move is merely noise in the larger trend hopefully taking place. Often your risk on any particular issue should be 10% to 20% below your entry. How do we reconcile this seeming conflict? Simply by defining your risk prior to entering and then adjusting the size of your position to accommodate both. For example, let's suppose your trading account is $100,000 (just to make the numbers simple). The 3% rule says that your maximum exposure should be $3,000. You are interested in purchasing XYZ's common stock at $20, but due to your analysis of the current volatility of this issue or of the market in general, you realize you must allow XYZ the room to trade down to $15 (25% below your entry) before your reason for purchase has been negated. That's a risk of $5.00 per share in this stock. Since our maximum exposure is $3,000, you divide $3,000 by the $5.00 risk per share, yielding a purchase of 600 shares. The formula is simply: (Portfolio Dollar Risk (3% of available capital) / Dollar Risk per share) = Amount of Shares Purchased In our example above 600 Shares of XYZ = $12,000 Commitment or 12% of available capital committed to this position. The risk (5 points x 600 shares) equals $3,000 or 3% of total available capital. Should the risk on the individual trade be more or less, the formula above will help you determine the amount of shares to be purchased.
I've Got A Secret System If you go to an investment conference or read a magazine, you are bombarded with opportunities to buy a software package which will show you how to day trade and make 1,000% a year. For $5,000 you can buy an "exclusive" letter (Just you and a thousand other readers, and their friends and clients) which will give you a hot options or stock tip. You will be shown winning trades which make 100% or more in a short time. You, too, can use this simple tested method to enrich yourself. Act Now. (Add 6.95 for shipping and handling.) Full disclosure here: I am a manager of investment managers. I look for investment managers and funds for clients. Most of what I look at are in the private fund or hedge fund world. I get to see the track records and talk with the creme de la creme of the investment universe - the true Masters of the Universe. These are the managers available only to accredited investors ($1,000,000 or more net worth.) This world is growing leaps and bounds as more and more sophisticated investors and institutions are looking at these managers now that mutual funds and stock managers are having bad years. None - not one - nada - zippo - zero of the best managers the world can deliver consistent results that you read about in these ads. The best offshore fund in the world for the five years ending in 2000 did about 30% a year. You can't get into it. But in 2001 they were flat. Steve Cohen can deliver some spectacular returns and has for almost 20 years. He has been closed to new money for years. But even this legend can't put up numbers like I see in the ads. Here's the reality. If you could make 20% a year steady, in five years - ten at the most-- you will be managing all the money you can run. Trust me, the money will find you. You will charge a 2% management fee and 20% of the profits. On $1 billion, that amounts to $60 million dollars in fees. That's every year, of course. Why would you sell a system that could do 20% a year? Once everyone knows about a system, it won't work like it has in the past. One of the problems I wrestle with every day is trying to figure out which investment styles may be at the end of their run. Every dog has its day in the sun. The trick is to figure out when the sun is setting. Now, saying that, there are exceptions. I get (or used to get, Rob) an email every day from a reader. Now I get weekly summaries. In it were his trades for the next day. He is uncanny. He is compounding at something like 300% year, with around 75% of his trades working. I called him and discussed his system. I was interested in starting a fund. The problem is that his style would top out (he thinks) about $1,000,000. After that, he would not be able to get enough trades. But he does nicely for himself. That means you could only have a fund for about $250,000 and let it grow, and of course there would be a thousand other problems. Could he sell his system? You bet. But the minute he did, it would stop working. I have looked at a manager in the Boston area. He has about the best sector rotation track record I have seen for the last five years. I called him up, wondering if I could place money with him. He said no. He will be at his maximum level, about $15 million, soon and then will have to close. I work with another manager who will soon close his fund at $250 million. That is all his style of investing can manage. Every style has its limits, whether it is $1 million or $250 million or $1 billion. Just because you have a successful operation with 25 stores doesn't mean you can expand to 500. There are physical limits to everything and every system. Knowing your limits, and the limits of your investment managers, is critical. Many of the spectacular blow-ups have been from managers who do not understand the limits of their style. Take the Janus 20 fund. This is a fund that focuses on the 20 "best" companies, mostly tech. They had an incredible record, and grew to manage tens of billions of dollars. This was good for the managers, as annual bonuses grew each year as well. They told their investors the secret to their success was doing their homework and being expert on analyzing companies. They were bottoms up value investors, looking for growth potential, and boy were you lucky to have found them. They were a bus load of investors on their way to a train wreck. No one seemed to think the party would end. But when it did, they had no exit strategy or even the ability to exit. If you own $5 billion in Cisco, you are not a shareholder. You are a partner. You are stuck. If you try to get out, the market will soon get the word that Janus is bailing, and the shorts will eat your lunch. In hindsight, their incredible track record was less brilliant investing and more simply was participation in the largest investment bubble in history, with no exit strategy. They got heads 8 times in a row. Smaller investors and funds could have taken the exact same approach, but because they were smaller would have the ability to exit.
Analyzing a Fund OK, here is a confession. There are thousands of funds and managers for me to investigate. When I go to my databases, I do a sort for high Sharpe ratios, low standard deviation, low betas and yes, good returns. Returns do matter. Then I begin to analyze. There are lots of questions to ask. First, I want to know "Why do you make money?" Then I ask, "How do you make money?" Then I want to know how much risk they are taking and the last question is, "How much money do you make?" (Besides the normal few score due diligence questions. For a list of those, see the Accredited Investor's Membership Guide at http://www.investorsinsight.com. Janus 20, to pick on them again, made money because they were in a bull market. Period. They lost money because they were in a bear market and they were a long only fund. Some "market timers" made good money in the last bull market, but lost their touch as we went into more volatile bear markets. The irony is that their systems need bull markets to be successful, but it was not until we were in a bear market that we knew that. Unfortunately, this was at precisely the time you wanted a market timer to work for you. So you have to find out what market they are trading in and look at their performance in light of that. That simple process will often tell you whether you are dealing with good managers or lucky traders. Of course, if you understand "Why?" they made money in the past, you have to ask yourself are the conditions likely to remain in place for them to continue to make money in the future? If they can give you a good reason for why they make money in their niche, then you start to look at how they do it. What is their system? Do they really have one or are they flying by the seat of their pants? Every manager has a proprietary trading system. You start with that as a given. There are lots of questions and analysis that is crucial at this point. As an aside, if a manager tells me about his unique trend-following program, I end the interview. To me, a trend-following system is just a system that hasn't blown up yet. In my experience, the percentage of trend-following systems which have experienced train wrecks after spectacular ten-year track records is way too high. I simply do not have the skills to figure out which ones are going to still be flipping heads in ten years, and which ones are going to crash, so I just leave that arena to smarter managers than myself. I am consumed with wanting to know how a manager controls risk. I understand that you can't make above market returns without risk. But not all risk is apparent from past performance. (The blow-up by Long Term Capital comes to mind. Right up until the end, they were as steady as you could find. Then: kA-Boom.) All styles will lose money from time to time. I want my risk to reward to be reasonable and controlled. When I meet a manager, and all he wants to do is talk about his track record, I find a way to quickly close the conversation. When they tell me they are trying to make the most they can, I head for the door. Maybe they are the real deal, but my experience says the odds are against it. It is not settling for being mediocre. Statistics and experience tell us that simply being consistently above average is damn hard work. When a fund is the number one fund, that is random. They had a good run or a good idea and it worked. Are they likely to repeat? No. But being in the top 50% every year for ten years? That is NOT random. That is skill. That type of consistent solid management is what you should be looking for. Isn't that what you are looking for in your trading account?
Happy Trading Bill