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Position Sizing - The Key to Stock Market Success

Ken Long

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It sounds unbelievable, but trading success has little to do with selecting the right investment or even having a great system. Instead, it has everything to do with “how much" you place at risk on any given trade. Investment professionals usually call this “asset allocation" or “money management. " However, they usually fail to understand that the key aspect that drives longevity and success in the market is “how much" to invest in any position.

Others work so hard to get themselves a good system, but then don't see that position sizing is the key element to getting what they really want. If you are fortunate enough to have a great trading system, it is much easier to meet your system objectives through position sizing, but even with an average system you have every reason to expect that you can meet your objectives and profit, if you understand how to position size properly. That's how important this key topic is.

One of the world's most prominent trading coaches and psychologists has observed that research has shown that there is no correlation between the confidence people have in a future trade and the likelihood of it being a success. This is especially true for traders with no proven system. In fact, there is probably a slight negative correlation between confidence level and the likelihood of success. In other words, the more confident you are, the more likely it is that the trade might go poorly. What I have seen over the years is that people are just not good at predicting success. This key insight is confirmed by a lifetime of research conducted by Nobel Prize winners Kahneman and Tversky, among others.

Do you really need to understand how markets work? No, you don't.

All you need to understand is how the concept that you are trading works. For example, if you are a trend follower, you just need to understand that the markets will occasionally move in very large trends. If you can catch the big moves, you'll make a lot of money. If you have a system that does that, then that's all that you need to understand about the markets.

If you are a value investor, then all you need to understand is why something is undervalued and be confident in your ability to determine that. The other two things you need to understand are (1) when your investments are no longer undervalued, meaning it's probably time to sell, and (2) when you might be wrong about your evaluation so you can safely abort and preserve your capital. You don't need to understand the market at all. Warren Buffett doesn't-he thinks the markets are irrational.

I highly recommend the work of Dr Van Tharp at the International Institute of Trading Mastery to look more deeply into this subject.

Ken Long, Chief of Research, Tortoise Capital Management

Adding value through independent research, combining technical analysis and human behavioral psychology

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