Some traders risk too much on their trades. For those traders, it is not a matter of IF they will go broke. It is a matter of WHEN they will go broke. In gambling, this is referred to as gambler's ruin. Imagine this experiment. You sit down at a roulette table. The roulette wheel is rigged and you know in advance that black will come up 70% of the time. You can still go broke. How could you possibly go broke when you know that black is going to come up 70% of the time? Though you know that 7 out of 10 spins will yield black, you don't know when those 7 will be. This is where money management comes in. How much do you bet on each spin to optimize your gains without ever risking going broke? There is a formula for this.
The Formula is called the Kelly Criterion.
When Long Term Capital Management went under in 1998, people were shocked. In hindsight, it is not shocking at all. Why did they go broke? A classic example of gambler's ruin. They were betting too much on each trade. It wasn't a matter of IF they'd go broke. It was a matter of WHEN.
Joel Stahl
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