Category: Risk Management

The odd thing about this article (PDF) describing Wall Street’s culture of risk? Why don’t the banks and other players have a plan to make money when shit hits the fan? Why is the unexpected viewed as something to manage and limit as opposed to being a great opportunity (trend following view)?

Risk and Volatility are often confused. Read this (PDF) for clarification.

Ed Seykota was recently asked:

“If you could give me ten rules to consider with respect to position sizing what would they be?”

He responded:

“Ten rules for position sizing:

1. Bet high enough to make meaningful profits when you win.
2. Bet low enough so you are ok financially and psychologically when you lose.
3. If (1) and (2) don’t overlap, don’t trade.
4. Don’t go adding a bunch of rules that don’t work, just so you have ten rules.”

Of course, Seykota and others will use detailed rules for risk management, that’s not the point with his answer. I liked his #4 answer.

Michael Mauboussin of Legg Mason offers this recent research on bet sizing (PDF). An excerpt:

“Edge is key. Recall the foundation of Kelly’s model rests on having a view that is different, and more correct, than that of the market. Having an edge requires understanding the market’s perspective. As Poundstone writes, ‘The stock ticker is like a tote board. It gives the public odds. A trader who wants to beat the market must have an edge, a more accurate view of what bets on stocks are really worth.'”

A Meditation on Risk appears in Fortune magazine:

Risk is like that. You stamp it out in one place, and suddenly it appears somewhere else. Bounteous evidence of this phenomenon can be found in finance. Hedge funds, for instance, are judged by their risk-adjusted performance. They adopt trading strategies that are likely to make money regardless of whether the overall market is rising or falling—betting, say, that similar securities will converge in price. Because there are so many funds doing the same thing, such trades are seldom very profitable. So to get a decent return, funds leverage their bets with borrowed money. The result is an investment vehicle that looks less risky—that is, less volatile—than a standard mutual fund but is in fact at far greater risk of blowing up if its trades go sour and its lenders want their money back. That’s what happened at Long-Term Capital Management, the famous hedge fund that collapsed in 1998.

More.

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Read the new book Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone. See my podcast interview with Poundstone here.

I recently saw the following comment regarding money management:

“Every system in our report uses very simple money management: Trade one contract per trading signal in the markets specified by the vendor with no pyramiding.”
Trading Guru

This is NOT money management. If you ever see anyone declare the above as money management walk away fast as you are about to be conned. Money management is not some set amount of shares or contracts picked out of thin air. Money management answers the question of “how much?” At all times, given the risk you are taking, the money you have, and the volatility of the market — you must know the optimal number of shares or contracts to be long or short.

Enjoy this post? Check out Lou Holtz’s View on the Bullshit talked about the divide in America.