I have interacted with many traders and first question i ask them during my interaction with them How much return you are expecting out of the market?
I get some weird answer like 50% ,100% on monthly basis and little sensible answer like 15-20%. So lets discuss a scenario to understand risk management in trading and returns expecting out of trading
Let’s say two successful PMS (Portfolio Management Service) approach you with the opportunity to invest and trade with them.
Both of these fund managers have been very successful over the past five years. In fact, they have both achieved an identical average annual return of 50%.
The key difference is that
Fund Manager A shows his trade-by-trade record and you see that he has booked a profit on an incredible 80% of his trades!
Fund Manager B, on the other hand, actually had many more losing trades than winning trades. His winning percentage was just 25%.
With this information, which fund manager would you choose to invest with?
How you answer this question tells a lot about how successful you are as a trader.
The vast majority of people would quickly choose to invest their money with Fund Manager A. After all, he wins much more often than he loses. He’s obviously “better” than Fund Manager B, right?
Actually, professional traders would choose to invest with Fund Manager B.
Because Fund Manager B is actually the SAFER fund manager of the two.
This is the “dirty little secret” of successful trading.
While novice investors see an incredible 80% winning percentage and think Fund Manager A has “The Midas Touch” (some kind of secret edge over his competitors), professional traders recognize that he’s just one losing streak away from blowing up his fund. And a streak of losing trades is inevitable. It WILL eventually come. It always does.
If Fund Manager A and Fund Manager B have both been able to achieve 50% annual returns, but Fund Manager A needs an 80% winning percentage to accomplish this record and Fund Manager B only needs a 25% win rate, it tells us that Fund Manager B is much better at limiting risk and managing profits.
In other words, Fund Manager B relies on cutting losses quickly and riding his winners longer. Fund Manager A relies on picking the right stock much more often than picking the wrong stock. While he’s been good at it so far, a single losing streak could virtually wipe him out because he’s relying on a winning percentage much greater than the law of averages to achieve his annual returns.
Risk management is the single biggest determining factor in the long-term success of a trader.
And risk management is NOT complicated.
If you develop a system that cuts every loss at 2% and allows an average winner to gain 10%, you don’t have to be a math whiz to figure out that this 1-to-5 loss-to-win ratio allows you to lose many more trades than you win and still achieve incredible profits with very little drawdown.
Nicolas Darvas, the creator of the Darvas System, recognized this “dirty little secret” of trading after years of trial-and-error. Once he designed a system to take advantage of this simple risk-to-profit method, he became a multi-millionaire.
Keep this “secret” in mind the next time you see one of those cheesy ads boasting “95% winning trades.”