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