“Risk is the amount and probability of an adverse or series of adverse events occurring” (Rotella, 1992). Substituting “losses” for “adverse events” results in the following: Risk is the amount and probability of a loss or series of losses occurring. Note that the probability of occurrence is as important as the total amount.
There has never been a system that was 100% profitable, that never took a loss on any trade or investment. Although such a system is the ideal, it has never been achieved despite the brilliant minds, sophisticated mathematics and theories, and superfast computer abilities that have addressed methods of investment. It likely never will be achieved. The search for such a perfect strategy can become an obsession but is genuinely futile, and losses are, therefore, inevitable in investing and trading.
Ruin is also likely. Every day some traders and investors are wiped out, largely because they did not utilize a portfolio method that included an assessment and control of risk. The area between perfection and ruin is a compromise between the gains and losses, known more commonly as rewards and risks, of a system or portfolio strategy. As can be imagined, the possibilities between perfection and ruin are limitless and have much to do with personal preference for risk. The reward side of a strategy we can fairly well quantify, as was shown in the previous chapter on systems, but the risk side is not so easily understood. The trade-off between the two will affect the ultimate success or failure of a portfolio strategy. That is the essence of money management—to maximize return at minimum risk. No home runs, no Holy Grails, no perpetual money machines—just plain and simple, consistent profits with minimum chance of losing all of one’s capital. The extremes, of course, range between highly leveraged options or futures contracts in a seat-of-the-pants, untested, untried system, and on the opposite side, strictly cash. The cash investment theoretically has no risk, whereas hotshot investments and systems are likely doomed. (A cash position does not have the risk of losing capital. Economists, however, will consider the inflation risk—the risk of the cash position losing purchasing power during inflationary periods.)
Ironically, a good system can lose money if it is not applied with concern for risk. Money management can turn it into a profitable, reliable system, but money management cannot help a system that does not work. Thus, as we covered in the previous chapter, the first step in creating a portfolio strategy is to find a workable system, preferably more than one. It need not be a supersystem—just one that consistently shows higher profits than losses. It can be based on fundamentals, technicals, or both. If you read interviews with successful traders and investors, you will find every one of them has a different method or system of entering the markets, but they all have in common a money-management system to protect against loss. Indeed, most will admit that money management is more important than any system. The second step is to decide on what markets and in which issues the system will trade or invest. The third step is to combine these systems and issues into a portfolio strategy. At this point, the subject of money management arises.
Because the theories of money management largely concern price and position size, the evaluation and control of risk are technical. Fundamental investors cannot assess risk in the marketplace with fundamentals alone. What should be the initial capital? What should be the trade size in contracts, shares, or dollars? What should be the risk strategies applied to these positions? What should be the execution style? Should the strategies be combined into one portfolio system, or should each system be treated separately? All these questions must be answered to manage the portfolio successfully, and all of them rely on technical studies and use of price action and signals. Generally, the systems will take care of themselves if properly tested and will give adequate entry signals, leaving the investor with the problem of how to best position from those signals and what exit strategies to use. The object of money management is to maximize the best situations and avoid or minimize those situations that can cause capital loss.
Because money management has much to do with determining the size of positions, it has also been called position sizing. However, there is more to it than just sizing. The parameters for risk avoidance, such as stops and exit strategies, are also important, as are diversification and execution methods. We cover some of the principal money-management strategies you should know and demonstrate methods of testing for and reducing the risk of ruin.
Source: Kirkpatrick II Charles D., Dahlquist Julie R. (2015), Technical Analysis: The Complete Resource for Financial Market Technicians, FT Press; 3rd edition.
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