Size of Bet
I once interviewed an aspiring young trader. After listening to his strategy, I finally asked what his 'run rate' was. He looked at me in the same confusion many readers will probably find themselves in now. Very simply, I asked, what did he expect his average daily profit and loss (pnl) to be. He was still confused and so, to clarify further, I turned to a gambling analogy and asked him if he played Blackjack. He duly replied yes and so I asked whether he liked to sit at a table where you make 5 or 25 dollar bets. At the 5 dollar table he replied – because he didn’t have that much money. And that was the point, it’s all relative.
If you are a billionaire, the 5 dollar table probably won’t move the needle much, whereas, if you only have 25 dollars you probably wouldn’t want to just make one bet at the 25 dollar table, as it could all be over in one go. Your pot of money that you have to invest is finite and, as such, you have to manage that carefully. Say you have 100 dollars and you bet 10 dollars on every flip of a coin. Can it come up heads 10 times in a row? Unlikely, but possible. There is then the chance that your money could all be gone after just 10 trades. Maybe we should hence only bet 5. Or maybe, we should bet smaller in the beginning and then increase when we have made some money?
I have met many fund managers who don’t understand that having a good trading signal or investment idea is only half the battle. There are actually three parts to every successful trade:
First, you have to make sure that your signal gives you a chance of success that is better than a 50/50. Despite many people’s assertion that they can call the market, say at least 60% of the time, the true numbers are probably rarely better than random.
Second, you need to know when to buy and when to sell – e.g. if you buy at 100, and the investment goes to 95, do you cut your risk or buy more? Similarly, if it goes to 105, do you sell and take profit or let it run? There are infinite combinations of when to buy or when to sell. Fact is, sometimes investments go down before they go up, and that makes this a horrible game where you almost never get it right.
But most difficult in any investment strategy is the third part, and that concerns the allocation of capital – e.g. how much to risk on each trade. Which brings us back to the run rate, the poor chap I interviewed many moons ago and the reason I used a gambling analogy. Unfortunately, most of our trades or investments don’t always work out the way we expect them to. Everything is down to the probabilities or where the cards may fall. Therefore, it is vital to adjust the size of our bets to protect our pot and give ourselves a chance for the statistics to work out in our favour.