Money Management, the Third Key to the Puzzle

Money Management, the Third Key to the Puzzle

In any trading or investing strategy you need three things – an entry and exit signal that you use, trade management (or how you manage the trade), and money management (or how much money you risk on each trade).

This article is about the third key to the puzzle – money management. It really is one of the most important parts of your trading or investing plan, and in a moment you will find out why. But first – this article is around 900 words. Although money management is extremenly important, if that’s too long for you please feel free to copy and paste it into Word or bookmark the page and come back later. I know you are busy, and I respect that.

Making and Keeping your Money

Now, take a walk through your imagination with me for a moment. Let’s say you buy a stock, and overnight the stock crashed, cutting the price in half (don’t laugh, it can happen!), Now, imagine that you put ALL of your money into this stock. You have just lost half of your life savings overnight!! There goes the family holiday, that new car you were eyeing, and possibly even the house. Needless to say, this would not be a conversation you would want to have with your husband or wife.

Now, imagine you only put one tenth of your money in this stock. Instead of losing the family holiday, you maybe lost a paycheck (despite the stock tanking severely). You might get away with all your limbs intact after telling your spouse this one…

Make More When You Win, Lose Less When You Lose

So, we’ve determined that it’s bad to put all of our money into one stock. But how do we split up our money to invest? Very simple – we start with the two percent rule. Using this rule, our aim is to never risk more than 2% of our total equity on any one trade. Now this may sound strange, so let me give you an example:

Let’s say you buy a stock at $30, and set your stop loss at $27. This makes the risk of your trade $3 (30 – 27 = $3).

You’ve saved hard over the last year and have managed to put aside $10,000 to invest. We don’t want to risk more than 2% of this on any one trade. So, we would not want to risk more than $200 (10,000 X 0.02 = 200).

So how many shares could we buy if our risk is $3 and we can’t invest more than $200? Well, $200 / $3 = 66 shares. And there’s your answer: 66 shares.

Why Do We Use the 2% Rule?

If our risk is only 2% each time we then have at least 50 chances before we lose all our money. And you and I could easily win more than 1 out of 50!! Especially using the other techniques on my blog.

As Warren Buffett said – “Look after the down side, and the up side takes care of itself”.

But It Gets Better Still

Our method so far is called Fixed Fractional Position Sizing. Fixed fractional position sizing is a fancy way of saying that with our 2% rule, we re-assess the dollars we risk every time we make a new trade. So our 2% is constantly changing the amount of dollars we invest, depending on our total bank account. This way our method naturally defends our account when we’re losing, and naturally compounds our account when we’re winning.

Allow me to give you an easy example of how we do this (there is some math involved here, but stay with me, this is important!):

Let’s say we’re using our $10,000 account from before – we were using 2%, or $200 risk each time. We make a few wins, and our account balance goes up to $11,000. So now instead of using $200 per trade, we will risk $220 per trade (11,000 x 0.02 = 220).

However, we then make a few losers, and our account goes down to $9,000. Instead of risking $220 per trade, we now risk $180 per trade (9,000 x 0.02 = 180). Thus, we can win more when we’re winning, and lose less when we’re losing – the ultimate aim of investing – and all done through money management.

In fact, after 20 losing trades in a row, we haven’t even lost 35% of our bank balance. However, if we use fixed fractional position sizing and we win 20 times in a row, our total bank balance would be $14,859 – a 48% increase. 35% when we lose, 48% when we win – what an easy way to gain the upper hand in the market!

Here is a table of how this works, using 2% each time:

Losing Trades	Bank Balance $	Risk / Loss $
	10,000
1	9,800	200
2	9,604	196
3	9,412	192
4	9,224	188
5	9,039	184
6	8,858	181
7	8,681	177
8	8,508	174
9	8,337	170
10	8,171	167
11	8,007	163
12	7,847	160
13	7,690	157
14	7,536	154
15	7,386	151
16	7,238	148
17	7,093	145
18	6,951	142
19	6,812	139
20	6,676	136

Win more when you win, lose less when you lose. With all the things going against you in trading and investing – brokerage costs, the institutional players and fund managers, conflicting news and fundamentals – good money management can help tip the odds back in our favor. And that makes me happy.

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