In a recent missive from Nick Colas, I found this awesome gem, from an anecdote about sitting with the in-house shrink of a hedge fund he used to work at:
The first year I worked at a hedge fund, I spent an hour late every Wednesday afternoon with the firm’s psychiatrist. It wasn’t just me. My trading partner was there. It was sort of like couples therapy with a little “Scared Straight” thrown into the mix. Every new guy at the firm had to spend time with “The Shrink”, and many of them kept going long after their rookie card expired.
The typical session was a ping pong game between the two topics which essentially outline the life of a trader: risk and return. Since the idea was to manage as much capital as possible without threatening the firm’s remarkable daily profitability, the most commonly used word in these discussions was “Size.” The conversation on a typical Wednesday afternoon went like this:
“Why didn’t you get bigger?!?!?” This was The Shrink’s key question about your best winning trade of the prior week. If you made 10% on a $1 million position, why wasn’t it $2 million? Or $5 million?
“Why’d you get so big in that?!?!” Yep – that would be for your biggest loser of the week. Buy 10,000 shares of something that lost $1/share, and the question became, “Shouldn’t you have ditched it when it was down $0.25?” Or “Why not buy 1,000 instead of 10,000 just to see how it traded?
“You’re too big in losers and too small in winners.” There is actually a lot of hidden wisdom in that question. To a trader, risk management is actually more about position size than anything else. High conviction ideas, with good insight, should ultimately be large positions as long as you don’t take too much of a loss waiting for things to work out. Low conviction ideas can grow into large positions if they are going in your direction.
It is a bewildering discipline to the uninitiated and is often counterintuitive. But do not dismiss the idea out of hand: a lot of people who are far less intelligent than you have much larger bank accounts because they know these rules and stick to them.
Josh here – Risk, Reward and Size is indeed an excellent little “three-dimensional construct” to keep in mind.
Nicholas Colas is the chief market strategist at ConvergEx Group, a global brokerage company based in New York.