An Excerpt from Dr. Tharp's Report on Money
Management.
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 $1,000 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. An account under $50,000 is small, but the average account is only
$5,000 to $10,000. 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 drawdowns 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.
| Drawdown |
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.
Managing Other People's Money
In the futures industry, when an account goes down in value, it's called a drawdown.
Suppose you open an account for $50,000 on August 15th. For a month and a half, the
account goes straight up and on September 30th, it closes at a high of $80,000 for a gain
of 60%. At this point, you may still be in all of the same trading positions. But as a
professional, your account is "marked to the market" at the end of the month and
statements go out to your clients indicating what their respective accounts are worth.
Now, lets say that your positions start to go down in value around the 6th of October.
Eventually, you close them out around the 14th of October and your account is now worth
about $60,000. And let's say, for the sake of discussion, that your account at the end of
October is worth $60,000. Essentially, you've had a peak-to-trough drawdown (peak =
$80,000, trough = $60,000) of $20,000 or 25%. This may have occurred despite the fact that
all of your trades were winners. It doesn't really matter as far as clients are concerned.
They still believe that you just lost $20,000 (or 25%) of their money.
Let's say that you now make some losing trades. Winners and losers, in fact, come and
go so that by August 30th of the following year, the account is now worth $52,000. It has
never gone above $80,000, the previous peak, so you now have a peak-to-trough drawdown of
$28,000 -- or 35%. As far as the industry is concerned, you have an annual rate of return
of 4% (i.e., the account is only up by $2,000) and you are now labeled as having 35%
peak-to-trough drawdown. And the ironic thing is that most of the drawdown occurred at a
time in which you didn't have a losing trade -- you just managed to give back some of your
profits. Nevertheless, you are still considered to be a terrible money manager. Money
managers typically have to wear the label of the worst peak-to-trough drawdown that they
produce for their clients for the rest of their lives.
Think about it from the client's viewpoint. You
watched $28,000 of your money disappear. To you it's a real loss. You could have asked for
your money on the first of October and been $28,000 richer.
Trading performance, as a result, typically is best measured by one's reward-to-risk
ratio. The reward is usually the compounded annual rate of return. In our example, it was
4% for the first year. The risk is considered to be the peak-to-trough drawdown which in
our example was 35%. Thus, this traders reward-to-risk ratio was 4/35 or 0.114 -- a
terrible ratio.
Typically, you want to see ratios of 2 better in a money manager. For example, if you
had put $50,000 in the account and watched it rise to $58,000 you would have an annual
rate of return of 16%. Let's say that when your account has reached $53,000, it had drawn
down to $52,000 and then gone straight up to $58,000. That means that your peak to trough
drawdown was only 0.0189 ($1,000 drawdown divided by the peak equity of $53,000). Thus the
reward-to-risk ratio would have been a very respectable 8.5. People would flock to give
you money with that kind of ratio.
Let's take another viewpoint and assume that the $50,000 account is your own. How would
you feel about your performance in the two scenarios? In the first scenario you made
$2,000 and gave back $28,000. In the second scenario, you made $7,000 and only gave back
$1,000.
Let's say that you are not interested in 16% gains. You want 40-50% gains. In the
first, scenario you had a 60% gain in a month and a half. You think you can do that
several times at year. And you're willing to take the chance of giving all or most of it
back in order to do that. You wouldn't make a very good money manager, but you might be
able to grow your own account at the fastest possible rate of return if you could
"stomach" the drawdowns.
Both winning scenarios, plus numerous losing scenario, are possible using the same
trading system. You could aim for the highest reward to risk ratio. You could aim for the
highest return. Or you could be very wild, like the Ph.D.s in the Ralph Vince game and
lose much of your money by risking too much on any given trade.
Interestingly enough, a research study (Brinson, Singer, and Beebower, 1991) has shown
that money management (called asset allocation in this case) explained 91.5% of the
returns earned by 82 large pension plans over a ten year period. The study also showed
that investment decisions by the plan sponsors pertaining to both the selection of
investments and their timing, accounted for less than 10% of the returns. The obvious
conclusion is that money management is a critical factor in trading and investment
decision making. (Determinants of Portfolio Performance II: An Update, Financial
Analysts Journal, 47, May-June, 1991, p 40-49.)
You now understand the importance of money management. Let's now look at various money
management models, so that you can see how money management works.
Money Management Defined
Money management is that portion of one's trading system that tells you "how
many" or "how much?" How many units of your investment should you put on at
a given time? How much risk should you be willing to take? Aside from your personal
psychological issues, this is the most critical concept you need to tackle as a trader or
investor.
The concept is critical because the question of "how much" determines your
risk and your profit potential. In addition, you need to spread your opportunity around
into a number of different investments or products. Equalizing your exposure over the
various trades or investments in your portfolio gives each one an equal chance of making
you money.
I was intrigued when I read Jack Schwager's Market Wizards in which he
interviews some of the world's top traders and investors. Practically all of them talked
about the importance of money management. 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
"You have to minimize your losses and try to preserve capital for those very
few instances where you can make a lot in a very short period of time. What you can=t afford to do is throw away your capital on
suboptimal trades." -- Richard Dennis
Professional gamblers play low expectancy or even negative expectancy games. They
simply use skill and/or knowledge to get a slight edge. These people understand very
clearly that money management is the key to their success. Money management for gamblers
tends to fall into two types of systems -- martingale and anti-martingale systems. And
investors and traders should know about these models.
Martingale systems increase winnings during a losing streak. For
example, suppose you were playing red and black at the roulette wheel. Here you are paid a
dollar for every dollar you risk, but your odds of winning are less than 50% on each
trial. However, with the martingale system you think you have a chance of making money
through money management. The assumption is that after a string of losses you will
eventually win. And the assumption is true -- you will win eventually. Consequently, you
start with a bet of one dollar and double the bet after every loss. When the ball falls on
the color you bet, you will make a dollar from the entire sequence of wagers.
The logic is sound. Eventually, you will win and make a dollar. But two factors work
against you when you use a martingale system. First, long losing streaks are possible,
especially since the odds are less than 50% in your favor. For example, one is likely to
have a streak of 10 losses in a row in a 1,000 trials. In fact, a streak of 15 or 16
losses in a row is quite probable. By the time you reached ten in a row, you would be
betting $2,048 in order to come out a dollar ahead. If you lose on the eleventh throw, you
would have lost $4,095. Your reward-to-risk ratio is now 1 to 4095.
Second, the casinos place betting limits. At a table where the minimum bet was a
dollar, they would never allow you to bet much over $50 or $100. As a result, martingale
betting systems, where you risk more when you lose, just do not work.
Anti-martingale systems, where you increase your risk when you
win, do work. And smart gamblers know to increase their bets, within certain limits,
when they are winning. And the same is true for trading or investing. Money management
systems that work call for you to increase your risk size when you make money. That holds
for gambling and for trading and investing.
The purpose of money management is to tell you how many units (shares or contracts) you
are going to put on, given the size or your account. For example, a money management
decision might be that you don't have enough money to put on any positions because the
risk is too big. It allows you to determine your reward and risk characteristics by
determining how many units you risk on a given trade and in each trade in a portfolio. It
also helps you equalize your trade exposure in a portfolio.
Some people believe that they are "managing their money" by having a
"money management stop." Such a stop would be one in which you get out of your
position when you lose a predetermined amount of money -- say $1000. However, this kind of
stop does not tell you "how much" or "how many", so it really has
nothing to do with money management.
Nevertheless, there are numerous money management strategies that you can use. In the
remainder of this report, I'm going to present different money management strategies that
work. Some are probably much more suited to your style of trading than others. Some work
best with stock accounts, while others are designed for futures account. All of them are
Anti-martingale strategies.
The rest of this article is continued in Dr. Tharp's special
report on money management.
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