From my previous Financial Times column: “Money management is like sex; everyone does it, but not many like to talk about it and some do it better than others. But while sex sites on the web proliferate, sites devoted to the art and science of money management are somewhat difficult to find.” Gibbons Burke
Money management is the key to successful share trading. Forget such magazine headlines as Ten Stocks You Must Buy Now.
Market success has next to nothing to do with the stocks you pick. It has everything to do with money management; research proves it and professional traders confirm it. Yet our obsession with stock picks continues.
So, what are the most important investment questions? Professional traders will tell you that success is about the “2×2 rule”.
That means you should ensure that your upside is twice your downside and never lose more than 2 per cent of your trading capital in a single trade.
For instance, with £20,000 capital, if you think Vodafone will go from 100p to 130p (a 30 per cent gain), you should equally not expect the stock to fall beyond 85p (15 per cent loss). And that worst loss should total no more than 2 per cent of your £20,000 capital, which is £400.
So, you should buy only £2,670 of stock at 100p (£400 is 15 per cent of £2,670). The formula is T=PR/(E-X) where: ● T is the size of the trade. ● P is the portfolio size (cash plus holdings). ● R is 2 per cent. ● E is the entry price. ● X is the pre-determined stop-loss exit price.
But surely, if you are a good stock picker, you don’t need to worry about money management? Wrong.
If you gain 30 per cent through stock picking, it takes only a 23 per cent loss to wipe out the gain. But if you lose 30 per cent, it takes 43 per cent to break even.
The same percentage loss and gain have unequal impact on your portfolio, and losses hurt more than gains benefit. The same percentage gain in the next trade from stock picking will not bail you out.
Why should you adopt a limit of only 2 per cent? Invest any more and you get too close to precipitous irrevocable losses from just a few trades.
Let’s say that you have four consecutive losing trades, which is feasible for even the best stock pickers. Say you lose 5 per cent of your portfolio on each trade.
With what’s left you now need to make a gain greater than legendary investor Warren Buffett achieves on average each year (23 per cent). Whichever stocks you pick, with poor money management you will suffer.
* The Probability of Success https://lnkd.in/dCuTiiH
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Alpesh Patel OBE