V.15:9 (390-396): The Basics of Managing Money by Mark Vakkur, M.D.

Why is money management one of the first items that profes-sional traders stress? Why would you think? Here’s an overview of risk and several simple mechanical approaches to money management.

Preserving capital is essential to a trader’s long-term survival. The only legitimate objective of trading or investing is to make money; if you trade for the thrill of it, you are playing the world’s most expensive sport. The objective of any money management system is simple: If followed, it will force you to cut losses short and let profits run. Most novice traders — and the bulk of today’s mutual fund investors — approach any decision with one question on their minds: What is my expected gain? They fail to ask a question that is far more important but is often overlooked: What is my potential loss? If your potential loss on a trade equals half your capital, two bad consecutive trades will wipe you out. If given the choice between avoiding a loss or participating fully in a gain, our first impulse is often to choose the latter over the former. But is that the better choice? Avoiding losses is far more important to long-term performance than making big profits because of two basic mathematical principles:

1. The more your account or portfolio grows, the greater dollar impact a given percentage decline will have on your equity.

2. It takes a far greater percentage gain to make up for a given percentage loss.