Risk & Money Management

Risk Management

Why does a system that includes Portfolio Management which already eliminates specific risk to a very high degree, need additional Risk Management?

Because Portfolio Management calculates the optimum combination of which stocks to buy, but does not calculate exit strategies. The purpose of Risk Management is to establish exit strategies to secure made profits.

What is Risk Management?

Basically the Risk Management of the Investor’s Coach calculates the point in time at which, it is best to exit a trade. While the other three components of the system – Technical Analysis, Money Management and Portfolio Management –

are mainly concerned with determining where and how much to invest. Risk Management is the module that tells the investor when to sell in order to secure made profits and reduce loss.

How does Risk Management work?

Risk Management is a very simple method that works by defining stops that trigger a sell signal when the share price falls.

There are two kinds of stops: absolute and relative stops. Absolute stops, where an absolute value is defined (e.g. $99.00) and a sell signal is triggered when the stock price falls

to this level. Trailing stops are defined in relation to the stock price (e.g. today’s stock price – 3%. Thus this stop rises with the stock and profits that were made during the rise are secured. Volatile trailing stops are basically trailing stops, but a crucial difference is that they can also account for the volatility of a market.

Volatile Trailing Stops

The Investor’s Coach works with volatile trailing stops. Volatility is the range in which a stock price / market moves up and down without it being a trend reversal.

In markets with high volatility, a sell signal can be triggered because the price of shares has fallen temporarily, only to be followed with a buy signal for the same stock soon after. But volatile trailing stops account for this fluctuation as they

have a volatility indicator as their basis. As a result of this, the weakness associated with absolute or trailing stops is thus eliminated.

The IC Expert places the best kind of stop for every market situation so that signals are neither given too early nor too late. The stop levels can vary in a matter of days depending on the market situation.

Money Management

The main goal of Money Management is to keep the trader in the market. The task of Money Management is to optimize the amount to be invested in order to have a maximized return on the ideal input. The desired result is geometrical growth of the capital.

Why Money Management?

Each trade on the stock market carries a certain amount of risk. Even if the trade looks very profitable, there is always the possibility of losing money. In a system where winning games have the lead, but losses are still possible (as is the

case at the stock market), hefty short term losses could leave the player unable to continue and recover losses (e.g. if too little capital is left for another investment).

How does Money Management work?

The precondition for well functioning Money Management is a trading system with a positive expected return - unlike, for example, the lottery, where the expected long term return is negative, meaning in the long run every gambler is more likely to lose rather than to win money.

The trading system of the Investor’s Coach has a positive expectation, due to Technical Analysis, Risk Management and Portfolio Management. However as a positive expected return can still result in a negative outcome, it is necessary to invest the optimal and not the maximal amount of money in each trade. Money Management has a risk-averse behavior. It

prevents too high stakes and thus avoids bankruptcy. Unlike Portfolio Management, which acts on the assumption of a 100% investment, Money Management calculates the ideal amount for investment. Depending on the current market situation the recommendation of the system can also be to hold onto the major part, or even all, capital.

For every system there exists one optimum at any time (=optimal f). This optimal f(raction) depends on the system and the market, thus it is not a stable value. It has to be calculated anew for every trade.

Why is Money Management necessary, if Portfolio Management is included in the system?

Portfolio Management calculates the optimal distribution of stocks within a portfolio. Therefore the Efficient Market Frontier is calculated. Each portfolio on this line has an optimal risk/return ratio. The more risk one is willing to take, the higher the expected return rises.

Money Management does not contradict this basic principle of Portfolio Management, but rather expands upon it. Although each portfolio on the efficient market frontier has an optimal risk/return ratio, there is still, according to Money Management, within this range one portfolio that has not only an optimal ratio, but also optimal growth of the money invested (as the

efficient market frontier is a steep graph at the beginning, and then flattens). The further to the right (in the flat area of the graph) a portfolio is placed the greater the risk, yet the possible return does not increase to the same extent. On the other hand, if a portfolio is placed in the very steep part, this means it has very low risk, yet the market potential is not fully exploited.

Thus only a combination of Money Management and Portfolio Management can determine the optimal investment to tap the full market potential.