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What are Risk Management andMoney Management?

October 1, 2010
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There are numerous risk and money management measures that can be adopted to protect capital but rather than focus on the varying methods of risk and money management, this post will look at “why you should apply risk management and money management rules to your investments”.

What risk is there to manage you may ask? The answer is the risk of drawdown. Whilst drawdown is a certainty, it must be limited according to how much risk YOU are prepared to take. This can all be achieved through disciplined adherence to personalised risk management rules.

Risk Management and Money Management are about:

  • Managing risk at the time of entry to a trade and during a trade. Specifically it is about managing the overall risk of your trading capital should the market turn against your open positions.
  • Sizing the amount of capital to allocate to the trade based on the probability of success, the risk being taken in the trade and current portfolio value.

You must also accept that risk Management and Money Management play a significant part in the psychological aspects of trading the market. Having a Trading System or strategy and not adhering to it or not applying Risk Management and Money Management rules is as good as denying:

  1. That you are subject to experiencing the human weaknesses of emotion and ego. Trading the market in this mode of denial or over-confidence is extremely dangerous. It displays a mindset of “I’m bigger and better than the market” or “I don’t make loss trades” or “I’ll intuitively know when to get out of a trade when the time comes”. Risk Management and Money Management, therefore, play a major role in controlling the effect that your emotions can have on individual trades and in having a structured approach to active investing.
  2. There are a vast number of different variables that can affect your portfolio at any given time most of which you don’t have any control over. Nobody knows what the immediate future holds and hence nobody knows what will happen next in the market or any individual trade. However you can control how you allocate your capital and how and when you exit your positions. You do this in recognition of the fact that you cannot control the millions of market variables that can and do affect your portfolio negatively.

From my experience, the vast majority of private investors don’t use or truly understand risk and money management. This statement could also be said of the big end of town; the financial managers, fund managers and financial institutions.

I hope this post is a catalyst for you to question your risk and money management practises.

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Comments

  • Steve says:

    max 15% of capital on any one trade – stop loss at 15% of that – 2.25% loss theoretically ( usually pretty close) only have 4 trades open at a time – risk 10% entire capital. If trades go beyond breakeven and you adjust stops – you are free to open another etc etc

  • Jordan says:

    I recently start trading. I prepared my trading plan but so far was not able to adhere to it. I fall victim of the ‘heat of the moment’ and usually buy stock on its high such as PRU and its prominent gravestone dodji of about ten days ago. Then I sell it at the bottom of pull back at the point when I should start looking at buying it, i.e. PRU last Friday. Emotions are indeed big problem for me. This is one of the reasons I just purchased SPA3 and I am looking forward to start using it. Let yuor system make decisions for me and I learn from it.

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