A quick follow up to my last post on risk management. In the approach I outlined in that post the first component of the strategy was to limit losses. I gave the example of limiting losses per trade to 1% of equity capital and my more conservative approach of 0.3% of equity capital per trade. Today I just want to highlight why this is so important.
The table and chart below show the % loss versus the return required to get back to breakeven.
This is simple math. If you have $1K and lose 50%, it takes a return of 100% to get back to even. The areas I highlighted in green are the only ones I consider acceptable. I probably should have put 15% and 20% in yellow. Most investors struggle with this axiom of successful trading for emotional reasons; loss aversion, fear of admitting your were wrong, etc. Whatever the reason, this needs to be mastered to be successful. And don’t think this only applies to day traders. As far as I’m concerned any investment you make with a horizon of less than 1 year is a trade.
That’s it. Keep your losses small and remember the corollary of this rule – let your winners run! In a future post I’ll tackle how a long term investor should use these concepts.
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.