I, like all traders have been on the hunt for the ‘Holy Grail’ of investing and trading for years.
Achieving high returns with little or no risk. Of course, no risk is impossible even if all positions were fully hedged. Just look at Long Term Capital Management (LTCM) back in the late 1990s who thought that with all the brain power of Nobel Loreates behind them they could indeed find the ‘Holy Grail’ of trading by diversifying and then leveraging their accounts several hundred times to achieve their outstanding returns which they did for a number of years before imploding in spectacular fashion.
In the end, like LTCM, once you have lost all your chips, you can’t continue to play. Which is the first rule. Never blow up your account no matter how confident or enticing the expected returns in theory sound.
What all successful traders and indeed I seek, are high returns with minimal risk as opposed to no risk and always be prepared for what Nassim Nicholas Taleb terms as a ‘Black Swan’ event. An unexpected event coming out of left field. Only if LTCM had learned of Nassim Taleb in it’s hey day.
This is where my previous post about personality and how that relates to trading success also relates to risk management. The amount of risk management is also subjective, although there are maximum parameters you really shouldn’t go beyond. Everyone is different, there isn’t a one size fits all. Some don’t mind taking vast risk to make potentially vast fortunes and are willing to ‘risk it all’ so to speak.
However, I believe that for most people including myself, would definitely not want to risk it all based on a desired single roll of the dice. Although I understand risk, I hate risk and seek to always minimize it as much as possible.
I remember my first ever ‘guru’ weekend trading seminar I attended when I first began, we (the class) were taught to split our account into 5 equal lots of 20% for each option trade. Can you imagine? Have several go wrong in a row which is a certainty in trading if you trade long enough, will literally wipe out your entire hard earned account. Being a beginner, even I thought that was ludicrous and thought I’d tweak his rules and dial it down to 10% or ten equal lots. Thinking back, I can’t even believe I thought 10% per position was OK. And you guessed it, that ‘guru’ is no longer around.
As I went along, I blew up several accounts on the way and taking some accounts to almost zero then topping it back up so they weren’t seen as another blow up just so I could trick myself to feel better. This is called self delusion. LoL.
It really did take me a while to realise and ask; How did the very best in the world do it? Hedge fund titans like David Einhorn, Carl Icahn, David Tepper, Jim Simmons abhor risk yet achieve spectacular year in and year out returns over long periods of time. They understand risk versus reward and strike a balance to achieve their desired return outcome .
There are some books which teach traders to take 2% risk on each trade. Although much better, this may also be far too much for most traders and not suit everyone because in my opinion even 2% risk is very risky. How do I know? Because I also used this 2% rule for many years. Now you may say, doesn’t it depend on the size of your account as 2% of a $10,000 ($200) is different to 2% of a $100,000 ($2,000)? Psychologically yes, as $2000 can buy much more than $200.
But reality, not at all because one must never think about the dollar loss amount but the percentage loss amount at all times. By risking too much even on a small account, if the trade goes against you and it will eventually, makes it very hard to recover practically and psychologically after a series of large losses to build your account into anything significant. Always remember, it takes a 100% gain to make up a 50% loss. So if even the best on the planet achieve 15-30% per year on average, what makes one think they can easily recover and achieve 100% to make up for their loss? I know I can’t and therefore avoid having this dilemma in the first place by risking much less on each individual trade.
Nowadays I risk no more than 0.02% to 0.5% depending on system as well as current market conditions for my own trading as well as for my investors. Yet, I can still comfortably achieve significant market beating returns every year. Some years I may under-perform but other years I make up for this and race ahead, taking little risk and know that my accounts as well as my investors funds never have to worry about a ‘Black Swan’ around the corner since no significant risks have been taken.
Let me repeat: You really do not need to take extraordinary risk to achieve extraordinary returns. Be the tortoise, slow and steady and let compounding perform it’s miracle.
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