Money Management

As you have seen, there is emotion involved in investing, and it can never be totally eliminated. However, it is also true that the more experience and practice you gain with the details of trading, the more you will be able to reduce your emotional reactions. But there is only one way to truly minimise your emotions, and this is money management.

Money management is the process of managing your money soundly, which involves investments, budgets, taxes and banking services. In trading, it is divided into:

• Risk Management analyses the potential risks of the invested capital, depending on its position in the market.
• Position Sizing identifies the capital to be invested in each trade and the allocation of the various asset classes, the so-called Asset Allocation.

Risk Management

Risk management is the process by which you measure or estimate risks and then develop strategies to manage them. The main function of risk management is to maximise profits by reducing the risk of losses.

A trader is, first and foremost, a risk manager and, as such, his primary goals are not to lose money and to ensure a stable income. Alexander Elder said: “to help ensure success, practise defensive money management. A good trader watches his capital as carefully as a professional scuba diver watches his air supply.”

Risk management is undoubtedly one of the keys to success in trading, but ironically, it is also one of the most neglected aspects. It becomes indispensable when you decide to invest a certain amount of money, or, in other words, when you expose yourself to financial risk.

You should always remember that trading has to be a business designed to make money over time. Only by knowing how to assess the risks and build a lasting strategy can you effectively contribute to keeping your business profitable. Risk management is fundamental in trading because, even before you open a trade, you need to establish how much you are willing to risk in that trade. That is the first rule for surviving in the long run.

Why do you trade? Because you have decided to make money. So the first fundamental rule is to build a strategy focused mainly on defending your investment. As Warren Buffett said: “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”

Many traders are overwhelmed by the anxiety of making a profit; they do not consider at all the size of their accounts and their exposure on the market (position sizing). They merely calculate how much they are willing to lose, and send the order on the platform, exactly as it happens on gambling websites (which is very different from trading).

By doing this, traders ignore the long-term return on their invested capital; they are simply going for the “jackpot,” hoping for “big winnings” right away. Not adopting a careful risk management strategy, on the other hand, is the easiest way to make sure that your losses will soon exceed your profits and, little by little, reduce your trading account to zero.

No analysis will be 100% certain, and your portfolio is at constant risk. So, applying risk management rules seems to be the only way not to sink. Risk management allows you to set aside your feelings and use your reason to focus on the real purpose of trading: earning money.

Position Sizing

None of us is the same, either as people or as traders. Everyone has different feelings and emotions; some people are more aggressive whereas others are more cautious. Risk management is the most important aspect of the trading process. The first step is determining how much of your capital you are willing to risk when you open a trade, according to your risk tolerance.

Risk tolerance is something subjective, so you will gradually learn what kind of approach you want to follow. It is evident, however, that if you are particularly aggressive from an early stage, your emotions will be even harder to handle, because you have little experience. When something goes against you, it will have an even more significant impact, complicating things.

My advice, therefore, is to take a quieter approach and then, gradually, become more or less aggressive depending on how things are going.

It is therefore always good to start small. Even a small investment involves some emotion, but if you risk a small amount of money, you will be less emotionally involved than with a large investment. Starting with small trades means handling positions with less stress.

Try to create a balanced profile, starting with a modest investment aimed at protecting your capital, with average risks and returns. Being different people (and traders), we also have different approaches: some of us are more aggressive while others are more conservative. You have to choose the level of risk that best suits you.

For example, I prefer quieter and stress-free trades, with many small profits that are steady in the long run. By trading like this, I also reduce all the negative factors and emotions that I covered in the previous posts.

If you sit in front of a computer knowing that you could lose hundreds or thousands of dollars every day, you trade with much more tension. If, on the other hand, you know that the potential loss is limited to a small percentage, your fears are limited too.

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