Tuesday, November 21, 2006
Risk allowances
Risk, while unwanted, is the reason why your portfolio has the ability to grow in value. The amount you earn on your investment is correlated to the amount of risk you are willing to take.
CDs and money market accounts are considered to be zero risk because they are insured by the FDIC in the US. Investments into hedge funds are usually higher risk because the capital is invested into various stocks and ETFs that are not guaranteed by any governing body.
You should never be willing to lose more than 2% of your account balance on any one transaction. This is a simple rule that the new investor and the hedge fund manager alike should follow.
To make money, you need to first figure your win to loss ratio. The number is not very important. Unlike competitive sports, you can still be a winner if your win to loss ratio is 1 win to every 99 losses. Your win loss ratio won’t decide whether or not your portfolio makes it to a bowl game. 
After you have found your win loss ratio you need to find the appropriate stop loss and take profit to set on each trade. Assuming your win loss ratio is 50:50, you should set your take profit slightly higher than your stop loss. This means that you should set your stop loss to an 8% loss on the trade but your take profit at 10%. After 100 trades you will have made 10% on 50 trades and lost 8% on the other 50 trades. While you were not perfect, you will have made money.
Some investors make money with ratios as low as 1:20. Investors who invest in the most speculative of investments are usually willing to lose 20 times for just one win. The one win will have been a huge gain; enough to cover the previous losses and then some.
A trader who only wins 1% of trades can beat a trader with 99% accuracy simply because of the amount of assumed risk and the amount gambled on each trade.
Don’t be upset if you can only win a few trades out of every 10. This is perfectly fine, all you need to do is adjust your stop loss and take profit levels so that you can profit from a losing record. The key is to cut your losses and let the winners run, but since we aren’t psychics this turns into a wild guess.
Study your recent trend history and develop a strategy for making the most out of your trades. Average your take profit to find what will work best for your strategy and make your stop loss conform to your win loss percentage.
Anyone can win 1% of trades but it takes an informed investor to turn that 1% into profits.