Hello everyone,
Today, I have a post that is different from what I usually write. Today’s post is more in the category of money management than technical analysis. You can substitute money management for trade management, trading strategies, etc. Basically, it is the part of trading that has not much relation to analysis (whether fundamental or technical) but I believe it is more important than analysis. It may sound silly – as it did when I discussed with friends – but my belief is that money management is more important than the analysis. I have quoted George Soros many times, and I shall do it again, to start off today’s post:
“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”
Bottomline of money management
George Soros essentially sums up the principles of money mangement in the quote above. Let us say you have a superior market analysis and your accuracy/success rate is as high as 70%-80%; in other words, you get 7 or 8 market calls right out of 10 (very uncommon, I am sure). That is very impressive. The thing is, if you are taking small profts along the way, and taking huge hits on loss-making trades, you will be burnt in the long-run. And, for those with lower success rates of 40-60% (in general, you get one right, then wrong on the next), you do not have to look at the long-run; in the short-term, you will end up asking yourself if there is any point in punting in the market, or for those doing highly-leveraged trading, you probably blow your account in a few weeks. Conversely – like you have heard many times from trading instructors/coaches at seminars, in online websites, etc – with good money management skills, which basically aims to maximise profits and minimise losses, you will make money in the long-run. You have to accept losses along the way, but your large profits are more than enough to trump the losses. If you are quite experienced, you know everything I have said. It is sounds simple: maximise your profits and minimise your losses. But, how many traders actually trade this way. Money management is not glamorous, money mangement is not sexy, money mangement is not complicated. But money management “makes or breaks”.
In the video below, you will see a short video on money management from Airelon Trading. Please come up with 6 minutes of your time to watch this video. It describes the attitute some have towards money management. When I told a friend how important money management was, he shrugged off saying that at the end of the day, it is about perfecting your analysis to the point you can get closer to being right all the time. Really?
Analysis is not all there is to trading
Success rate takes centre stage in the world of trading. We want to know the success rate of a system. We want to know how many winners/losers a successful trader has. And we certainly ignore those who have bad win rates even if they actually end up making more money than us. If you have superior analysis, good for you. It is definitely not detrimental to have superior analysis. All the more, if you combine good analysis with good money management skills, trading should be a breeze for you. But, for the majority who have to be content with lower success rates, money management can save you.
If there is one thing I have learnt over the years of reading up on the different successful traders/investors in the world, it is that they all have different methodologies of analysis. In the end, we can categorise all the analyses into two broad categories of technical analysis and fundamental analysis (or a third group under statistics for those who use a mechanical, numbers-based, high-tech approach, and consider technical analysis as an inaccurate representation). Also, we can say that this investor is similar to the other investor in certain ways (usually the philosophical side to trading/investing). However, at the end of the day, their methods are different. The way they look at a market is different. Even in the realm of technical analysis there are different styles. Fundamental analysis is also not an entirely united camp; there are different kinds of fundamental analysis: growth investing, value investing, even GAARP – growth at a reasonable price – talk about trying to have the best of both worlds!
What I realise is that there is no one way to trading/investing successfully. And even in many other fields, the cliche sentence that “there is more than one path to success”. The point I am trying to make is that people are constantly seeking for the best system, the best methodology – because of Warren Buffett’s popularity and the deserved respect for him, people all over the world buy books on value investing hoping to be the next oracle-of-”insert your hometown here” – but they are searching in vain. We are all wired differently, and we all have different personalities that will affect how we invest or trade. Also, analysis is not all there is to the game. And definitely not a single way of analysis. Different analyses can still produce results. It is not that all the successful traders or investors rely on a single way of analysis.
Money Management is “universal”
Money management, on the other hand, speaks different languages. You do not need to couple it with technical analysis only. Money management does not require a chart. Money management does not need candlesticks. Money management certainly is not useful only to statistics – based trading. This is the neutrality of money management. It is something that all traders/investors need to be mindful of. You cannot ignore it. You cannot avoid it. And, you should approach it with as much earnestness as analysis.
Defence in sports
Now, I want to draw analogies (or parallelism, as I like to call it, but the dictionary does not support it) to the sports world. I am a very active person and also try to follow the professional sporting world as best as I can. While I am not a sports commentator, I believe I have learnt quite alot from sports that I can apply to other areas of life.
I support the Los Angles Lakers, a team in the NBA (National Basketball Association). I start off with a quote that is famous in the sports arena: offence wins games, defence wins championships.
I remember following the 2007-2008 season closely. In the finals, the LA Lakers played against the Boston Celtics. The Celtics won 4-2 in the end. After that, most fans and respected commentators brought forward a point: the Celtics won because of better defence. Their half-court defence was solid and organised. In the next two years, the Lakers had obviously learnt their lesson, and shored up the defence. They even beat the Celtics in 2009-2010. At the ameteur level, defence is even more important. Basketball is a high-tempo sport. Teams trade baskets and rack up many points within minutes. The only way to win many games and build a strong record is to have good defence. You cannot win with offence in the long-run. It is solid defence that gives you a good foundation to then attack and win.
Next, probably of more interest to most of us in Singapore – I support Manchester United in the EPL. After the Beckham era, the manager, Sir Alex Ferguson, started rebuilding the squad. It generally takes a while to actually replace the “core” of a team. The solid partnership of Rio Ferdinand and Nemanja Vidic came up by the start of the 2007-2008 season. I remember during those days, it was fascinating to see the two foster a very strong partnership behind. And Evra, in technical terms (and my opinion), was one of the best defenders on the flanks. It is no surprise Manchester United won the coveted Champions League that season. Of course, most people will point to the trio of Ronaldo, Rooney, and Tevez as the reason United were dominant for the middle part of that decade. However, people forget that United had a very solid back four. Not to forget, United had one of the best-ever goalkeepers in Edwin Van Der Sar. In that same season, United also conceded the least goals (for themselves) for the decade in the EPL – 22 goals against. Majority of people will only focus on the exciting things. The goals, the flair, the dazzling tricks – all the things that make up a highlight reel. But just like money management, not many see the boring, unexciting, seemingly unimportant aspects of, in this case, football. Defence is key. Just look at the more exciting Arsenal Football Club – known to be the Barcelona of England. Not to poke fun at one of United’s rival, but for all the style in their brand of football, they have not won a major trophy since 2005. Of course, many people will start debates on this and that. But, this is not a sports blog, so I shall not say more.
The reason defence is so important in sports is that good defence means you always have a chance to win. In football, if you are going to let in many goals, your offence has to churn out even more than you let in to win. Why is it that weaker teams always have to set up well defensively if they want to stand a chance to win? Simply because if they defend well, they just have to score one or two and come out as winners. Weak teams do not win because they manage to score 4 or 5 goals after letting in 3 or 4 goals early in a match. Underdogs win games with very narrow and low scorelines. Defence keeps you in the game.
There is more to write on sports, but sometimes we should not go too far with analogies. They simply show slight parallels between two unrelated realms.
How defence applies in trading
For those who do not like the sports analogy I illustrated, I hope that the other parts of this post will give you some food for thought. The reason why I see money management as a kind of defensive mechanism rather than an “offensive” one, even though good money management maximises profits, is that money management keeps you in the game. You can tell yourself that you live another day to trade after making small losses. Contrast to a trader who makes wild losses that can blow out of proportion on a leveraged account. Money management keeps you in the game so that your winners can propel your account to higher heights. Also, like defence in sports, money management is not given the attention it deserves. That is because it is not as exciting as a chartist monitoring the roller coaster he sees on a chart, or a fundamentalist reading between the lines and finding financial gems that no one sees. That is also because money management is simple, and not as complicated and “professional-looking” as analysis.
