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RVB's Market Musings

What began here as an avenue to interact and learn has far exceeded those goals.

If you are a prospective employer, please consider this site a place where you can see my passion for investing...

Tuesday, May 17, 2005

LEARN: What is "money management"?

What is this concept called "money management"? Some of you may have never heard of such a topic, and that's ok, but this is THE SINGLE MOST IMPORTANT CONCEPT IN INVESTING. Period.

To understand the concept let's imagine a simple game. Here are the rules: You flip a coin. Every time the coin comes up heads, you get 2 dollars. Every time it comes up tails you get 1. Would you play this game?

You should answer "Absolutely!" Why? Well, because you can expect to make a dollar for every flip of the coin. For anyone who has taken a statistics course, this is known as expected value.

So, you may have heard people say "always protect your capital" or "don't lose money". What they really mean is that if you sell your losers quickly, you have a chance to allow your money to go to work for you. Much like a good defensive team in football, if you give up 8 yards every 3 plays, you're going to be very successful. So, you need to come up with some kind of "Money Management" scheme that allows for success. There are many ways out there to manage money, and they are beyond the scope of this article, but I will give a very simple example of just one:

-Always predefine a price at which you determine your position is "wrong" and you will automatically exit
-Set a target price for your position
-Divide your potential profit by your at-risk dollars. Never enter a position unless your expected reward is more than 3 times your expected risk
-Never risk more than 2% of your account on any position (known as an "Oh $h**" clause)

In theory with the above rules, you will still make money even if you are only right 40% of the time. Can you live with something like that?


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