Don’t Buy A Stock Without Reading This First — Seriously

If there’s one piece of advice that all successful market speculators can agree on it would be that profitability hinges on proper position sizing. Sizing too big or inconsistently will invariably result in your eventual ruin. This statement cannot be understated.

Take small positions, define risk, and remain systematic. All it takes is some simple statistical reasoning and you’ll quickly understand why this concept is so important.

“You can give someone a winning system and they will find a way to lose money trading it if they’re not also position sizing correctly.” — @jboorman

Jon Boorman is one of the best trend followers we know. His story is also unique. He transitioned from working at big banks in London to running his own company. He’s now a trend follower managing money on behalf of investors. Boorman adheres to strict rules of position sizing and has several great examples of highlighting its importance. We recently sat down with him and spent over an hour talking about his journey and the meaning of position sizing. In our talk, he brought up a study by Dr. Van Tharp — an expert in the subject of trader development. One of his famous studies is called the Marble Game. Van Tharp describes it as follows:

“Imagine playing a game for money in which marbles are drawn out of a bag and then replaced. 60% of the marbles are white. If one of the white marbles is drawn out, you win whatever you risked. The other 40% are blue. If one of the blue marbles is drawn, then you lose whatever you risked. This game has an expectancy of 20¢. That is, over a large number of trials, you’ll make 20 cents for every dollar you risk. That means it’s much better than any game you’ll ever play in Las Vegas.
But what percentage of the people who play it make money? I have introduced this game numerous times in talks that I’ve given at seminars and conferences. Typically, we don’t play for real money, but the winner (i.e., the person who ends up with the most “money” after 50 trials) is given a prize. The results at a typical talk are that one third of the audience ends up broke, another third of the audience loses money, and only a third of the audience makes money.

Whoa, wait, what — there’s a game with huge win expectancy and the majority of people lose money? How?

Poor position sizing. In the simplest form, imagine if you played the game above and bet your entire net worth every single time. Sure you might see a few hefty returns. Sure you could win 50 times in a row (highly unlikely). But all it would take is one loss to eradicate everything you’ve earned and wagered. That’s just one example. Think of all the different wagers you could take and how quickly you could lose money if your bets are too big.

An interesting example of this could be that scene from Rounders when Matt Damon finally tricked Teddy KGB into going all in. That was it.

“It’s about avoiding the worst of the downturn. Everyone focuses on getting the upside. All I’m trying to do is capture most of the upside, while avoiding the worst of the downturn.” — @jboorman

And that’s why we want to once again highlight the key component of position sizing. The key is to never let one bad trade, one bad decision, or one stroke of bad luck take you out of the game. Bets should be small enough and well calculated so that none of those possibilities can take you out. Now, spend some time with us as we dissect this crucial component of any trader’s arsenal: