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Position Size
In Jack Schwager's Market Wizards book in which he interviews some of the world's top traders and investors. Practically all of them talked about the importance of money management, and position size. Here are a few sample quotes:

"Risk management is the most important thing to be well understood. Undertrade, undertrade, undertrade is my second piece of advice. Whatever you think your position ought to be, cut it at least in half." -- Bruce Kovner

"Never risk more than 1% of your total equity in any one trade. By risking 1%, I am indifferent to any individual trade. Keeping your risk small and constant is absolutely critical." -- Larry Hite

John was a little shell-shocked over what had happened in the market over the last three days. He'd lost 70% of his account value. He was shaken, but still convinced that he could make the money back! After all, he had been up almost 200% before the market withered him down. He still had $4,500 left in his account. What advice would you give John?

Perhaps your answer is, "I don't know. I don't have enough information to know what John is doing." But you do have enough information. You know he only has $4,500 in his account and you know the kind of fluctuations his account has been going through. As a result, you have enough information to understand his money management -- the most important part of his trading. And your advice should be, "Get out of the market immediately. You don't have enough money to trade." However, the average person is usually trying to make a big killing in the market, thinking that he or she can turn a $5,000 to $10,000 account into a million dollars in less than a year. While this sort of feat is possible, the chances of ruin for anyone who attempts it is almost 100%.

Ralph Vince did an experiment with forty Ph.D.s. He ruled out doctorates with a background in statistics or trading. All others were qualified. The forty doctorates were given a computer game to trade. They started with $10,000 and were given 100 trials in a game in which they would win 60% of the time. When they won, they won the amount of money they risked in that trial. When they lost, they lost the amount of money they risked for that trial.

Guess how many of the Ph.Ds had made money at the end of 100 trials? When the results were tabulated, only two of them made money. The other 38 lost money. Imagine that! 95% of them lost money playing a game in which the odds of winning were better than any game in Las Vegas. Why? The reason they lost was their adoption of the gambler's fallacy and the resulting poor money management.

Let's say you started the game risking $1000. In fact, you do that three times in a row and you lose all three times -- a distinct possibility in this game. Now you are down to $7,000 and you think, "I've had three losses in a row, so I'm really due to win now." That's the gambler's fallacy because your chances of winning are still just 60%. Anyway, you decide to bet $3,000 because you are so sure you will win. However, you again lose and now you only have $4,000. Your chances of making money in the game are slim now, because you must make 150% just to break even. Although the chances of four consecutive losses are slim -- .0256 -- it still is quite likely to occur in a 100 trial game.

Here's another way they could have gone broke. Let's say they started out betting $2,500. They have three losses in a row and are now down to $2,500. They now must make 300% just to get back to even and they probably won't do that before they go broke.

In either case, the failure to profit in this easy game occurred because the person risked too much money. The excessive risk occurred for psychological reasons -- greed, the judgmental heuristic of not understanding the odds, or in some cases, the desire to fail. However, mathematically their losses occurred because they were risking too much money.

What typically happens is that the average person comes into most speculative markets with too little money.  As a result, these people are practicing poor money management just because their account is too small. Their mathematical odds of failure are very high just because they open an account that is too small.

Hundreds of thousands of hopefuls open up their speculative accounts yearly, only to be lead to the slaughter by others who are happy to take their money. Many brokers know these people don't have a chance, but they are happy to take their money in the form of fees and commissions. In addition, it takes many $5,000 accounts to feed a single multi-million dollar account that consistently gets a healthy rate of return.

Look at the table below. Notice how much your account has to recover from various sized Drawdown in order to get back to even. For example, losses as large as 20% don't require that much larger of a corresponding gain to get back to even. But a 40% drawdown requires a 66.7% gain to breakeven.

Gain to Recover
5 Percent
5.3% Gain
10 Percent
11.1% Gain
15 Percent
17.6% Gain
20 Percent
25% Gain
25 Percent
33% Gain
30 Percent
42.9% Gain
40 Percent
66.7% Gain
50 Percent
100% Gain
60 Percent
150% Gain
75 Percent
300% Gain
90 Percent
900% Gain

and a 50% drawdown requires a 100% gain. Losses beyond 50% require huge, improbable gains in order to get back to even. As a result, when you risk too much and lose, your chances of a full recovery are very slim.

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