Lower Risk with a Money Management System

Money management is one of the most significant parts of any trading system. Money management is that portion of your trading system that tells you how much to risk on any investment or set of investments. How many dollars of your investment should you put on any stock at a given time, and how much risk should you be willing to take?

Practically all of the top traders and investors talk about the importance of money management. The following are a few quotes from them:

•"Risk management is the most important factor and it should be well understood. Undertrade, undertrade, undertrade is my second piece of advice."

•"In order to take advantage of a positive expectancy investing system that has a large number of trades that lose a small amount of capital, and few winning trades that yield a large amount of profits, you need to make enough trades, so that even if a lot of them yield small losses, you will be able to find the few that do make you a lot of money. To achieve this in practicality, money management is key."

•"Never risk more than 1% of your total equity in any one trade. By risking 1% only, you are indifferent to any individual trade. Keeping your risk small and preset is absolutely critical to lessen drawdowns."

•"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."

Some money management systems, such as the Martingale system, increase bet size when the trade is going against you. Some people try to buy more of a stock that goes down. This is the wrong way to trade. Cut any losses at 7% to 8%—much sooner if possible. Since the stock market shows trends, averaging down is simply adding more to a losing position, and thus a losing strategy.

On the other hand, systems where you increase your risk when you win do work. Smart physician-investors know to increase their bets within certain limits when they are winning. Money management systems that work call for you to increase your position size when you make money. This can mean additions to your position when a stock pulls back to the 50-day moving average, or on a breakout from a second-stage base. This is also espoused by good investing disciplines, like William O'Neil's CANSLIM system, and others.

So there are two aspects to money management: the percentage of total capital to be invested in one particular stock, and the stop-loss percentage on that particular stock. Some people believe that they are managing their money by having a stop in place. However, this kind of stop does not tell you how much of your total equity to invest in one stock. Your money management model determines the size of your position.

is a private money manager affiliated with Sierra

Capital Planning in northern California. He runs a fee-based business

and a hedge fund for qualified investors. For more information,

call 877-467-8657 or visit www.sierrainvestor.com. Avanish

Agrawal contributed to this article.

Michael Doran