Money, Martingales and Pyramids

This is an extract from my book Financial Speculation and looks at the tortuous topic of money management in an investment portfolio.

No definitive right answers of course!

“There are three main elements to a successful investment; direction, timing and money management. Each of these is progressively more difficult to master. Many market players (though not usually the most successful) seem to think that correctly anticipating market direction is the key to success; in fact it’s a relatively small part of the trading experience. Undoubtedly timing is important, but again not as vital as one may at first believe. But by far and away the most important element in trading is money management. One can be excellent at direction and timing, but if you fail to follow prudent money management rules you will come unstuck. Equally, and this may seem somewhat perverse, one can be relatively poor at direction and timing but disciplined money management rules will at least reduce your problems and may even keep you profitable.

Needless to say money management and risk rules area very personal decision; we all have different ideas of acceptable risk. As we have seen earlier, the dangers of rationalising away losses can be fatal, and so strict adherence to any rules is important. This can be far harder than one may imagine – it is one thing to have rules, and quite another to follow them. Institutions also have money management regimes, with VaR type structures, but these tend to concentrate only on potential losses; ideally a comprehensive money management regime should also address the profits side of the equation.

Most money management is plain commonsense, and is about creating a realistic structure that you can and will strictly follow. The first basic step is usually to divide your trading capital into a number of equal amounts with which to trade – ten is usually thought to be a sensible number. With this you never commit more than 10% of your capital to any single trade. Many speculators play in geared markets (so-called margin trading or via futures contracts) and here any gearing or leverage of more than five times your initial capital is courting disaster (Remember at this level your P&L account is effectively moving at five times as fast as the underlying market). In fact it may be more prudent to limit one’s gearing to no more than three times.

So for an account size of US$100,000 three times gearing gives a total exposure of US$300,000 with no more than US$30,000 committed to any single trade. When you trade, one of two things can happen; you either make money or lose it. Either of these outcomes causes a dilemma; is it right to keep the same trading size, or increase or decrease it?

Starting with losses there is a school of thought that says you should increase your stake after a loss, in an effort to re-coup the previous set-back. This has echoes of a well known gambling strategy called a Martingale; this involves doubling your stake on each successive bet, and is particularly popular amongst roulette players betting on a colour or on the odd or even series. This strategy is superficially attractive, but of course assumes the gambler has an extremely large amount of betting capital. To restrict such strategies, casinos habitually impose table limits that prevent gamblers with very deep pockets from constantly doubling up. Some investors have tried similar tactics to recoup trading losses, but this strategy has the horrific quality that you double your gearing on a reduced capital base. As such it makes no sense at all, and increases your exposures at alarming and probably unsustainable rate.

On a more positive note, what about the more pleasing problem of how should we react after a string of wins? Some would argue that we should increase the investment size (after all each trade is now a smaller proportion of the increased capital pot); though there is a counter-argument that says after a run of successes you should in fact reduce your activity as it is likely that losses will be bound to be coming your way. The problem with the first idea is that of course you have chosen to gear up after your wins, and so any subsequent loss will be correspondingly greater. Equally not increasing you deal size means you are no longer keeping each trade at the same proportion of your capital, and arguably are not maximising your profit potential.

My preference in both the case of losses and profits (I put losses first just to reinforce the dismal fact that losses are a constant part of the investment scene, and so we should accord them due prominence) is to only re-adjust the trade size once a year. Admittedly, if during the year you experience a string of losses, your bets are getting proportionately bigger (because of the reduced capital base) but at a far lower rate than actually increasing their size. Equally in a period of success, you are now effectively ‘under investing’ but that may be prudent after a string of winners. All of this is of course rather subjective and depends on the scale of your winners and losers – an alternative idea instead of the annual review is to re-base your deal sizes every time your capital base increases or decreases by a fixed amount or percentage.

These issues whilst simple hide quite a degree of complexity. Apart from closed out winning and losing trades, some investors choose to adjust the deal size whilst still in the trade. The most common strategy here is called the pyramid or reverse pyramid trade. Here investors refine their trade rules by sub-dividing the individual capital amounts per trade. For example going back to our original figure of US$30,000 per trade, they then divide that into three amounts of say US$15,000, US$10,000 and US$5,000. The idea being that they commit half of the allocated capital at the initiation of the trade and then feed the other two amounts into the market at the appropriate time. Then when closing the position they sell the entire amount in one go. This sounds a good idea, in that you are buying into a rising market and you will achieve an attractive average ‘in-rate’. However, of course, in practice it’s extremely difficult to execute, what for example are the ‘appropriate’ levels to add the second and third portions?

The reverse pyramid idea merely reverses this idea, suggesting that you should commit only a small proportion (say US$5,000) in the initial part of the trade, so that if it goes wrong early on, you have only committed a small part of your capital. If the market does continue to go your way you can of course add the other two larger lumps. The obvious problem here of course is that the average in-rate of the trade is pretty poor, and you may have effectively put the trade on too late or at an unfavourable overall rate.

On balance I think pyramiding and its various derivations should be avoided, it adds a number of subtle complexities to what is already a complicated decision process. It may also sow all sorts of seeds of indiscipline regarding actually cutting loss making positions.

As I said earlier money management is an extremely personal and subjective topic – I find that the best rules are clear and simple; and that you must discipline yourselves to follow them. There are a large number of books on the topic that often have a strong statistical bias and attempt to discuss optimum solutions; that is all fine and well but at the end of the day its your discipline that counts not just the most elegant mathematical solution. It’s likely you will find simple rules the easiest to execute, so stick with them

To summarise then, I find dividing my capital in to ten portions, keeping my gearing low and reviewing my rules annually a happy medium. One final tip – keep a trade diary recording all the details of the trade, the simple act of writing down your investment strategies seems to help keep focus.”