[ The Opportunist ] by Niger Lim

This section is one of the most important sections you will ever read about trading.

Why is it important? Well, we are in the business of making money, and in order to make money we have to learn how to manage it. Ironically, this is one of the most overlooked areas in trading. Many traders are just anxious to get right into trading with no regards to their total account size. They simply determine how much they can stomach to lose in a single trade and hit the “trade” button. There’s a term for this type of investing….it’s called GAMBLING!

When you trade without money management rules, you are in fact gambling. You are not looking at the long term return on your investment. Instead you are only looking for that “jackpot”. Money management rules will not only protect us, but they will make us very profitable in the long run. If you don’t believe me, and you think that “gambling” is the way to get rich, then consider this example:

People go to Las Vegas all the time to gamble their money in hopes to win a big jackpot, and in fact, many people do win. So how in the world, are casino’s still making money if many individuals are winning jackpots? The answer is that while even though people win jackpots, in the long run, casino’s are still profitable because they rake in more money from the people that don’t win. That is where the term “the house always wins” comes from.

The truth is that casinos are just very rich statisticians. They know that in the long run, they will be the ones making the money—not the gamblers. Even if Joe Schmoe wins $100,000 jackpot in a slot machine, the casinos know that there will be 100 more gamblers who WON’T win that jackpot and the money will go right back in their pockets.

This is a classic example of how statisticians make money over gamblers. Even though both lose money, the statistician, or casino in this case, knows how to control their losses. Essentially, this is how money management works.If you learn how to control your losses, you will have a chance at being profitable.

You want to be the rich statistician…NOT the gambler because in the long run, you want to “always be the winner.”

So how do you become this rich statistician instead of a loser?

So we know that money management will make us money in the long run, but now we’d like to show you the other side of things. What would happen if you didn’t use money management rules?

Consider this example:

Let’s say you have a $100,000 and you lose $50,000. What percentage of your account have you lost? The answer is 50%. Simple enough. Now, what percentage of that $50,000 do you have to make in order to get back to your original $100,000? It’s not 50%–you’d have to make back 100% of your $50,000 to get back to your original $100,000. This is called drawdown. For this example, we would’ve had a 50% drawdown.

The point of that little illustration is that it is very easy to lose money and a lot harder to make it back. We know you’re saying to yourself, “I’m not going to lose 50% of my account in one trade.” Well we would certainly hope not!

However, what if you lost 3, 4, or even 10 trades in a row? That couldn’t possibly happen to you, right? (Sarcasm used) You have a trading system that wins 70% of the time, so there is NO way you could lose 10 trades in a row. (Even more sarcasm used)

Well, while you may have a good system, consider this example:

In trading, we are always looking for an edge. That is the whole reason why traders develop systems. A trading system that is 70% profitable sounds like a very good edge to have. But just because your trading system is 70% profitable, does that mean for every 100 trades you make, you will win 7 out of every 10?

Not necessarily! How do you know which 70 out of those 100 trades will be winners?

The answer is that you don’t. You could lose the first 30 trades in a row and win the remaining 70. That would still give you a 70% profitable system, but you have to ask yourself, “Would you still be in the game if you lost 30 trades in a row?”

This is why money management is so important. No matter what system you use, you will eventually have a losing streak. Even professional poker players who make their living through poker go through horrible losing streaks, and yet they still end up profitable.

The reason is that the good poker players practice money management because they know that they will not win every tournament they play. Instead, they only risk a small percentage of their total bankroll so that they can survive those losing streaks.

This is what you must do as a trader. Only risk a small percentage of your “trading bankroll” so that you can survive your losing streaks. Remember that if you practice strict money management rules, you will become the casino and in the long run, “you will always win.”

Let me illustrate what happens when you use proper money management and when you don’t…

Here is a little illustration that will show you the difference between risking a small percentage of your capital compared to risking a higher percentage.

You can see that there is a big difference between risking 2% of your account compared to risking 10% of your account on a single trade. If you happened to go through a losing streak and lost only 19 trades in a row, you would’ve went from starting with $20,000 to having only $3,002 left if you risked 10% on each trade. You would’ve lost over 85% of your account! If you risked only 2% you would’ve still had $13,903 which is only a 30% loss of your total account.

Of course, the last thing we want to do is lose 19 trades in a row, but even if you only lost 5 trades in a row, look at the difference between risking 2% and 10%. If you risked 2% you would still have $18,447. If you risked 10% you would only have $13,122. That’s less than what you would’ve had even if you lost all 19 trades and risked only 2% of your account!

The point of this illustration is that you want to setup your money management rules so that when you do have a drawdown period (losing streak) you will still have enough capital to stay in the game. Can you imagine if you lost 85% of your account? You would have to make 566% on what you are left with in order to get back to breakeven. Trust me, you do NOT want to be in that position. In fact, here is a chart that will illustrate what percentage you would have to make to breakeven if you were to lose a certain percentage of your account.

You can see that the more you lose, the harder it is to make it back to your original account size. This is all the more reason that you should do everything you can to protect your account.

So by now, I hope you have gotten it drilled in your head that you should only risk a small percentage of your account in each trade so that you can survive your losing streaks and also to avoid a large drawdown in your account. Remember, you want to be the casino…NOT the gambler!

Another way you can increase your chances of profitability is to trade when you have the potential to make 3 times more than you are risking. If you give yourself a 3:1 reward/risk ratio, you have a significantly greater chance of ending up profitable in the long run. Take a look at this chart as an example:

In this example, you can see that even if you only won 50% of your trades, you would still make a profit of $10,000. Just remember that whenever you trade with a good risk to reward ratio, your chances of being profitable are much greater even if you have a lower win percentage.

http://www.businessweek.com/smallbiz/content/aug2008/sb20080811_233552.htm?campaign_id=rss_topStories

William Baker, marketing professor at San Diego State University, shares research findings on networking, particularly its relation to innovation

by Karen E. Klein

He spoke recently to Smart Answers columnist Karen E. Klein about his findings. Edited excerpts of their conversation follow.

Last year, you studied 1,600 business executives from a cross-section of U.S. firms, half of them small and midsize companies and half large companies. What questions were you hoping to answer?

I wanted to see how what I call "external social capital" affected company performance. So I controlled for the effects of other business variables I’ve studied in the past and added networking to the mix.

And what was the bottom line—did networking make a significant difference?

I found it had a strong main effect on performance measures relating to innovation, most notably the ability of firms to develop new products.

Were entrepreneurs who do a lot of networking more successful in terms of profit or market share?

I didn’t see a direct impact on those things, but those who do a lot of networking were more likely to be innovative and to have a large percentage of new products.

How did you define and measure networking?

External social capital means the extent to which firms go outside of their walls to talk to people—inside or outside of their industry—who they think have a valuable opinion. So entrepreneurs with high external social capital do a number of things, from business round table groups to industry associations, to talking to their competitors and suppliers, and even going out beyond their industry and talking to opinion leaders in other areas.

I think there’s a trend where firms are doing this more and more as they recognize you can’t depend on the group-think mentality inside your company. After all, entrepreneurs tend to hire people who think the same way they do and have the same perspective.

That might be particularly true in small companies, where there are fewer employees, perhaps less variety of expertise, and a smaller universe of ideas.

And it’s a very dangerous thing in this world to not share information. People are paranoid about giving out information, and you don’t want to be stupid, but you have to think that competitors can also be colleagues. The old business models are changing and you’re putting yourself at a positional disadvantage if you’re just relying on internal information now.

What was the correlation between networking and how risk-averse the company is?

Not all small firms are aggressive innovators, but among those that are, increased networking seemed to slow down their market responsiveness time, while improving their results at the same time. On the other hand, in small firms that are not very aggressive, networking speeds up their ability to respond quickly to marketplace events and influences the success of their innovation ability—more so than with large firms.

So either way, networking led to positive outcomes. But it would seem counterintuitive to have improved results with slower market response time. How did that work?

If you run a really aggressive company, you are adept at being open-minded in terms of learning. But you can also be a reckless innovator who’s more concerned with developing new ideas than understanding if there are markets out there for them. What the study found is that if you have a weak social network, you might just be a bull in a china shop. But if you get a diversity of ideas about your company and products, that might slow you down a little bit, in a good way.

And how about those more cautious small companies?

The opposite was true for the more conservative companies. If they’re out doing a lot of networking, they’re likely to spot trends they might have missed and they’re likely to realize that they have to react more quickly than they normally would. That way, by the time they catch up with trends they won’t be too late to get market share.

So external social capital has the ability to slow down the too-reckless companies and open up a wider horizon for more conservative companies. Either way it is positive.

What practical advice would you give entrepreneurs based on your study?

You’ve got to broaden your lens. Go out into your own industry and even look at other industries for innovation. When consumers make decisions, they don’t just base them on the best practices in a given industry. If they see great customer response and service in one industry, they’ll expect the same in other industries. And if you pick up on the good things all sorts of companies are doing, and bring them over into your company, there’s the breeding ground for competitive advantage. It’s something new you can do rather than copy your competitors.

Karen E. Klein is a Los Angeles-based writer who covers entrepreneurship and small-business issues.