A fundamental driving force in human nature is avoiding loss or the risk of loss. Realism in establishing goals, especially financial goals, involves assessing tolerable risk and balancing risks against reaching the goals. Another driving force of human nature is pleasure; in the case of investing one’s own money, profits. These two ideas clash, and sensible risk avoidance strategies go out the window when novice investors fall prey to the promises of those selling courses, books or software promising fast, easy money.
Understanding the risk-reward ratio is the starting point for prudent money management. When developing money management skills, the novice trader must learn to focus on risk before reward. A number of factors require careful consideration when looking for the trading tools that allow the trader to establish a realistic risk-reward ratio.
Losses are inevitable. Even though traders inherently understand that the unpredictability of the market can result in a slump, a series of losses, few are prepared to accept this. Mentally preparing for a string of losses helps the investor avoid rash decisions that generally lead to losses of capital or opportunity.
Properly judging a system or technique from its historical performance requires a large number of trades or test samples. One hundred, 200 or even 300 samples don’t tell a reliable story, especially for the investor who understands that risk management is one of the key ingredients in profitable trading. One thousand samples should be sufficient to include market situations where loss prevention, rather than chasing profits, is a decisive factor in trading. Simply put, the more an investor manages risk, the greater the likelihood of substantial, positive returns.
“I’ve never seen a trading system advertised yet that doesn’t suggest big profits,” said one trader. Many new traders, and often experienced traders, are lured into investment products and training based upon claims made by instructors and authors who have found more money in teaching than in doing. Those new to trading must evaluate their personality, lifestyle, strengths and weaknesses before investing in a book, course or software. Not all traders are fit to take on the challenges of the market. An honest evaluation of one’s ability to put risk before reward has saved many an investor from loss.
Trading is a very emotional act. The fear of losing and the greed that can come with multiple wins both make even the most experienced trader an emotional wreck. Emotional trading will cause a trader to make avoidable money management mistakes. They often focus more on the gains, and when they see themselves losing they become anxious.
A trader who puts risk first is less emotional; they are prepared for potential outcomes and don’t get panic attacks and anxiety that ultimately cloud the judgment of many traders. By carefully calculating risk and knowing exactly one’s limits, a trader is less likely to make common trader mistakes such as moving a stop-loss or prematurely pulling out of a trade.
Few things that can make a person as worked up and emotional as trading. Gaining money gives the trader a rush, a boost of confidence, a feeling of achievement. Loss, on the other hand, often makes the trader experience self-doubt, anxiety and, in some cases, depression. Traders who are consistently profitable are able to control their emotions. By objectively assessing one’s personal strengths, weaknesses, objectives and resources, one can then clearly define risks and set concrete limits – boundaries that will keep trading in check. Being able to effectively manage emotions is a developed skill; developing that skill requires an understanding of risk management.
Traders cannot be consistently profitable without good money management skills. Most experienced trade experts stress consideration of risk-to-reward ratio when managing a trading account. However, the majority of traders continue to consider the potential rewards more than the risk required to reach their expected return. What they don’t grasp is that trading is not just about winning. Losing is a huge part of trading; it’s inevitable. Traders who have not prepared themselves to go through a string of losses inevitably wipe out their accounts. Those who have established a solid risk management discipline and religiously follow consistent, established trading guidelines are many times more likely to achieve solid returns.
A trader who manages risk thinks more about how to prevent loss instead of becoming obsessed with the potential reward. This trick is more effective because rewards don’t need to be managed. They take care of themselves. Risks must be managed at all times. Successful traders think more about loss prevention than focusing on rewards. Focusing on risk management offers a bonus to the trader; it supports emotional management. Money management and emotional managing are not separate skills in trading. They work together. A trader who has developed good money management skills by thinking about risk first is emotionally prepared for losses. These traders know where to set stop-losses; they are prepared for unexpected economic events and financial uncertainties. Being prepared for a bad trading day puts them in a position to guard their account balances as well as to recognize and take advantage of situations.
Thinking about risk first also helps traders keep emotions in check and manage gains. A trader who trades based upon the emotional rush felt after a big win is at risk of becoming a gambler. This type of trader can easily wipe out an account by over-trading in order to maintain the emotional high. But traders who have managed money know and understand the importance of keeping emotions in check when in winning mode. They do this by paying careful attention to how they feel when they win and then taking steps to control their emotions. Most successful traders record not just the trades, they also record their thoughts and feelings at the time of the trade so they establish trading guidelines that can be a constant reminder on the dangers of excessive exuberance.
A less apparent trait of successful traders is the money management skills they use to develop strategic trades that provide them an edge. Strategic traders are less likely to be emotional; they are not relying on luck. Established goals, trading procedures and limits give them more control over their losses and gains and curb the highs and lows emotional traders experience. Strategic traders carefully consider the potential risk for each reward.
Money management and emotional management, when used together, make the probability of success much greater. To develop money management skills, the focus should be more on the risk. And managing risk is the key element in keeping profit-killing emotions in check.