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Trading say twenty stocks or one hundred stocks does not protect you from the overall market risk (systematic risk). But trading twenty stocks does protect you from unsystematic risk. (eg. the company cooked the books and the story broke over night, the stock gaps down from a close of $98 to an open of 90 cents.) In this case, you have essentially lost only about 5% of your portfolio (1/20) if you diversified over 20 stocks. If you bought only one stock, like a friend of mine did a few years ago, options actually on Oxford Health a few days from when its story broke...... well he is still working for living, because he really did bet his retirement. It's obvious that betting everything on one stock is stupid, but what is the right number? I'm comfortable with twenty and can sleep at night, even when leveraged. If you trade long enough, you will get bit hard by one of your stocks, somewhere, sometime, when you least expect it. Been there, done that.
I agree that in general, most stocks move in the same direction as the market, so that owning a hundred stocks or even 10 won't protect you from market risk. You would have to diversify into something like pork bellies or cotton, to have a truly uncorrelated investments. But you better really measure the correlation yourself. Mutual funds are similar. Why have three mutual funds that are almost perfectly correlated?
Kevin Campbell
In a message dated 9/23/03 9:14:21 AM Central Daylight Time, psytek@xxxxxxxx writes:
MONEY MANAGEMENT, ahh such a sweet controversial topic :-)))
Can somebody enlighten me?
1) With an avarage of 1% per trade (why per trade and not per position?), do we have to trade 100 stocks? Anybody on this list having 100 actively-traded stocks in their portfolio?
2) At 1% per position one needs a sizable portfolio... 100 stocks priced at an average of $20 and 500 shares would add up to $1,000,000 of actively traded dollars. How many on this list do that? No answer expected :-)
2) If you have 1% invested in 100 stocks and the whole market dives, so will your portfolio, i.e. if 50 stocks track the market you'll be down 50%. So how does this 1% protect you against whole market dips?
The answer to the above is probably that 1) you must diversify in stocks/sectors that make opposite moves but this is probably more difficult than money management, 2) that your perfect trading system should get you out of the market in time. Doesn't this mean that 1) and 2) are prerequisites to MM and most be solved before the application of MM?
Now, this doesn't mean I do not agree with money management :-) just that that the way it is presented doesn't help the small tarder very much. Small (limited budget) traders need to develop different typ of MM. What are the MM rules for small traders?
For short term trading I like to think along these lines:
1) Use the best system possible; never stop trying to improve it. Aim for a high % winners: it will keep you trading.
2) Start each new stock small, a sudden large investment represent the risk of a sudden large loss
3) Use maximum loss stops that prevent you from ever dipping into your initial equity.
4) use profit stops, they can really improve system performance.
5) reinvest profits to reach maximum positionsize gradually
6) increase your position size in small increments by increasing the Positionsize with 1-2% extra cash with each trade
7) use all the tools available to you: know your trader workstation and order types, use conditional orders.
8) diversify over sectors and stocks
With AB version 4.5 we will probably see w whole new range of MM topics surface, hopefully some that can be backtested better.
Happy trading,
Herman.
Ps. Yes, I have read some of the books on this topic but they all appear to be written for fund managers, not for the small trader.
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