## A Primer On Risk Management

Risk management is the single most important thing you do as an investor. While not a glamorous endeavor, it is the difference between making money and losing money over the long run.

In golf, you “Drive For Show and Putt For Dough”, and in the market the same method holds true. The little details that new investors often overlook are actually the most important. Investing is not about waiting for the perfect setup and then putting your entire portfolio fully-leveraged into one position. The longer you trade, the more you will realize that every trade has the potential to fail, and that often times your biggest gainers will be the ones you had the lowest expectations for. If you don’t have a disciplined exit point and position size before you place a trade, you will eventually lose money when you encounter a streak of losing trades.

Let’s look at a few scenarios to get an idea of how the math works. Using the classic coin flip example, let’s see what happens when we take different amounts of risk and have different lengths of losing streaks with a hypothetical $100,000 account:

**Taking 1% Risk Per Trade** (Account loses 1% Each Time) With The Following Consecutive Losses In A Row:

- 1 Trade – $100,000 x .99 =
**$99,000** - 2 Trades – $100,000 x .99 x .99 =
**$98,010** - 3 Trades – $100,000 x .99 x .99 x .99 =
**$97,029** - 4 Trades – $100,000 x .99 x .99 x .99 x .99 =
**$96,059** - 5 Trades – $100,000 x .99 x .99 x .99 x .99 x .99 =
**$95,099** - 6 Trades – $100,000 x .99 x .99 x .99 x .99 x .99 x .99 =
**$94,148** - 7 Trades – $100,000 x .99 x .99 x .99 x .99 x .99 x .99 x .99 =
**$93,206** - 8 Trades – $100,000 x .99 x .99 x .99 x .99 x .99 x .99 x .99 x .99 =
**$92,274** - 9 Trades – $100,000 x .99 x .99 x .99 x .99 x .99 x .99 x .99 x .99 x .99 =
**$91,351** - 10 Trades – $100,000 x .99 x .99 x .99 x .99 x .99 x .99 x .99 x .99 x .99 x .99 =
**$90,438**

**Taking 2% Risk Per Trade** (Account loses 2% Each Time) With The Following Consecutive Losses In A Row:

- 1 Trade – $100,000 x .98 =
**$98,000** - 2 Trades – $100,000 x .98 x .98 =
**$96,040** - 3 Trades – $100,000 x .98 x .98 x .98 =
**$94,119** - 4 Trades – $100,000 x .98 x .98 x .98 x .98 =
**$92,236** - 5 Trades – $100,000 x .98 x .98 x .98 x .98 x .98 =
**$90,392** - 6 Trades – $100,000 x .98 x .98 x .98 x .98 x .98 x .98 =
**$88,584** - 7 Trades – $100,000 x .98 x .98 x .98 x .98 x .98 x .98 x .98 =
**$86,812** - 8 Trades – $100,000 x .98 x .98 x .98 x .98 x .98 x .98 x .98 x .98 =
**$85,076** - 9 Trades – $100,000 x .98 x .98 x .98 x .98 x .98 x .98 x .98 x .98 x .98 =
**$83,374** - 10 Trades – $100,000 x .98 x .98 x .98 x .98 x .98 x .98 x .98 x .98 x .98 x .98 =
**$81,707**

**Taking 3% Risk Per Trade** (Account loses 3% Each Time) With The Following Consecutive Losses In A Row:

- 1 Trade – $100,000 x .97 =
**$97,000** - 2 Trades – $100,000 x .97 x .97 =
**$94,090** - 3 Trades – $100,000 x .97 x .97 x .97 =
**$91,267** - 4 Trades – $100,000 x .97 x .97 x .97 x .97 =
**$88,529** - 5 Trades – $100,000 x .97 x .97 x .97 x .97 x .97 =
**$85,873** - 6 Trades – $100,000 x .97 x .97 x .97 x .97 x .97 x .97 =
**$83,297** - 7 Trades – $100,000 x .97 x .97 x .97 x .97 x .97 x .97 x .97 =
**$80,798** - 8 Trades – $100,000 x .97 x .97 x .97 x .97 x .97 x .97 x .97 x .97 =
**$78,374** - 9 Trades – $100,000 x .97 x .97 x .97 x .97 x .97 x .97 x .97 x .97 x .97 =
**$76,023** - 10 Trades – $100,000 x .97 x .97 x .97 x .97 x .97 x .97 x .97 x .97 x .97 x .97 =
**$73,742**

And for those of you that love to pull out the driver on the short Par 4′s with water surrounding the green, here are some more extreme examples.

**Taking 5% Risk Per Trade** (Account loses 5% Each Time) With The Following Consecutive Losses In A Row:

- 1 Trade – $100,000 x .95 =
**$95,000** - 2 Trades – $100,000 x .95 x .95 =
**$90,250** - 3 Trades – $100,000 x .95 x .95 x .95 =
**$85,737** - 4 Trades – $100,000 x .95 x .95 x .95 x .95 =
**$81,450** - 5 Trades – $100,000 x .95 x .95 x .95 x .95 x .95 =
**$77,378** - 6 Trades – $100,000 x .95 x .95 x .95 x .95 x .95 x .95 =
**$73,509** - 7 Trades – $100,000 x .95 x .95 x .95 x .95 x .95 x .95 x .95 =
**$69,833** - 8 Trades – $100,000 x .95 x .95 x .95 x .95 x .95 x .95 x .95 x .95 =
**$66,342** - 9 Trades – $100,000 x .95 x .95 x .95 x .95 x .95 x .95 x .95 x .95 x .95 =
**$63,024** - 10 Trades – $100,000 x .95 x .95 x .95 x .95 x .95 x .95 x .95 x .95 x .95 x .95 =
**$59,873**

**Taking 10% Risk Per Trade** (Account loses 10% Each Time) With The Following Consecutive Losses In A Row:

- 1 Trade – $100,000 x .90 =
**$90,000** - 2 Trades – $100,000 x .90 x .90 =
**$81,000** - 3 Trades – $100,000 x .90 x .90 x .90 =
**$72,900** - 4 Trades – $100,000 x .90 x .90 x .90 x .90 =
**$65,610** - 5 Trades – $100,000 x .90 x .90 x .90 x .90 x .90 =
**$59,049** - 6 Trades – $100,000 x .90 x .90 x .90 x .90 x .90 x .90 =
**$53,144** - 7 Trades – $100,000 x .90 x .90 x .90 x .90 x .90 x .90 x .90 =
**$47,829** - 8 Trades – $100,000 x .90 x .90 x .90 x .90 x .90 x .90 x .90 x .90 =
**$43,046** - 9 Trades – $100,000 x .90 x .90 x .90 x .90 x .90 x .90 x .90 x .90 x .90 =
**$38,742** - 10 Trades – $100,000 x .90 x .90 x .90 x .90 x .90 x .90 x .90 x .90 x .90 x .90 =
**$34,867**

As Refined Investors, I want to continually pound the table on this concept of risk management. It is inevitable that at some point in your investing career you will have a streak of losses. How badly you are damaged by those losses will greatly impact your final account balance when you eventually retire from the game. Just like in golf, where it is much easier to make a triple bogey on a hole (3 strokes over par) than it is to make a birdie (1 stroke under par), it is much easier to take a big loss on a trade than to make a big profit. Therefore, it is more important that you limit your losses and let your winners run, which is typically the opposite of how our brains think. We tend to hold onto our losses, hoping that they will turn back into profits, while we keep a short leash on winning trades because we don’t want to “give back” the gains.

Mathematically, it is also harder to earn back the money once you’ve lost it. The way that percentages work, here is how much money you will have to make just to get back to your original account balance after a string of just 5 consecutive losses, which almost all of us will experience in our careers:

- 5 Losing Trades In A Row With 1% Risk =
**5.15% to get back to even** - 5 Losing Trades In A Row With 2% Risk =
**10.63% to get back to even** - 5 Losing Trades In A Row With 3% Risk =
**16.45% to get back to even** - 5 Losing Trades In A Row With 5% Risk =
**29.24% to get back to even** - 5 Losing Trades In A Row With 10% Risk =
**69.35% to get back to even**

So the next time that you want to buy a leveraged ETF, or take on a huge position size, acknowledge how much risk you are taking (I will cover this in a different post). Trying to find a great entry point with a definable level of risk should be your first priority in this game, not how much money you are going to make after you push the place order button. We spend a lot of time waiting for the right entries and using a multitude of different methods to do so, but there is no guarantee that any of them will be successful trades.

Percentages will compound in the positive direction as well, and that is why the rich get richer on the same percentage move as everyone else, because their starting balance is higher. It takes money to make money. Over time, you can actually take less risk and make the same amount of money, a beautiful thing.

As Refined Investors, we take the bogeys when they happen and move on…but by playing for par and avoiding the pitfalls that come from using our driver when we shouldn’t, we will all be surprised at the number of birdies on our scorecard at the end of the day. And that final number is the only thing that matters.

Good trading all.

Steve Chapman, TRI