Stock market trading tips: Why are most traders so bad at risk management?
Answered by Anurag Bhatia, Hedge Fund Manager, Minance Capital.
Because we don’t think mathematically.
I’ll give you an unbiased coin and ask you to toss it a hundred times; for each heads your stocks rise 20%, for each tails your stocks fall 18%, would you take this deal?
If you said yes, you’re a bad risk manager.
We humans take rash decisions. Our brains read this as: Heads I win, I make 20%. Tails I lose, I lose 18%. 18 is lesser than 20, and the coin is unbiased so I will make 2% every time! Hence $$$$$$$.
How a risk manager sees it: Since it’s an unbiased coin I can divide the whole set of outcomes into pairs: HT HT HT HT …. For each pair do I come out ahead?
Lets say you started with a 1000 bucks worth stocks. You tossed the coin and it’s a head. Yay, you now have 1200 bucks. You toss again, you know lose 18%. Crap! You should still be up right, because 18 < 20? No. You now lose 18% on 1200, You lose 216 bucks. You’re down to 984.
Think numbers and model risk.is a good place to start.
originally answered at Quora.
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