Saturday, March 15, 2008

Position Sizing and Risk Management

With the recent horribly tragic events of real estate and debt instrument investment experiences, some public information on risk management deserves attention. Position sizing deals with the portion of total asset exposed to risk/reward.

Putting it all on the line or "betting the ranch" tends to carry exceptionally high risks of ruin, since it leads to large losses as soon as the underlying event goes south. It would make more sense to allow many different "bets", all with positive statistical expectancies, to occur at once. As the law of large numbers kicks in, a positive return will eventually follow. Luck determines the speed of it.

Quick example-

Basic trend following stock investment strategies carry approximately 33% winning rate on average. (Some still come out profitable after long strings of trades, because the average winners carry much larger size than the limited losing trades.)

This basically implies that out of each 10 lowly correlated positions, one would expect 2-4 winners at best, but those home-run winners will bring all the money home.

To execute this and lower the risk of total loss, many professional traders commit (i.e. risk) 1-5% of capital per trade/investment unit. Strings of losing trades occur from time to time, and this scheme remains the only method of surviving them before the large winners ensue. The more probabilistic trials, the probability of the statistical edge kicking in becomes much larger.

All said and done, you want to run the investments like a casino, where the edge sits on your side. Luck determines whether an individual investment unit ends profitably or negatively. Study and gain that positive expectancy. Plan the position sizes meticulously. The money will follow.

As Featured On Ezine Articles

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