Quick poll on the 1% rule

Hi
I'd read a while ago about using a 1% rule as a guide to limiting individual risks in the context of one's own personal assets. I've also begun to wonder if everyone sees it the same way, so I'd be interested to see what folks think.

Here is some context so we are all on the same footing:
- lets say "personal wealth" means savings, property (that part which isn't owned by the mortgage company!) and maybe other investments in varying degrees of liquidity.

- shall we say that an "individual risk" is the amount you might realistically lose between placing a trade and it hitting (or zooming straight past) a stop loss.

So, the above description forms one definition. Suppose though you have several trades out at the same time (shares again in this example, lets say they are all position trades lasting a few weeks) and they all suffer the same correlated risk in a market correction.

One might have picked them so that they didn't appear to be likely to suffer correlated risks, but one might still get it wrong. What approach do folks take then?

Any thoughts appreciated.

Strangelydifferent

You might be interested in picking up a book about risk management, as this is a classic problem. The usual approach is basically to construct a covariance matrix and try to put the standard deviation of the portfolio to whatever figure.

The problem with this is that when things go wrong suddenly everything becomes correlated. See sub prime for a perfect example of this!

In terms of trading shares, one would ensure that each share is in a sector/industry showing relative strength. This should form part of the risk management strategy. The idea being that when a market correction occurs, your portfolio does not suffer such a large correction as the main market. Sometimes this works, sometimes it does not but it is best to follow the smart money in terms of choosing sectors/industries and put yourself in the strongest position possible.

Hi
Ok, thanks, this is encouraging.
supposing I mentally divide this risk into three:
i) "everyday" risks, potentially ammenable to statistical analysis - I hadn't yet thought of assessing covariances between stocks and currencies, I've only eyeballed long term plots and I find it difficult to separate covariance from the more obvious general correlation that most stocks have with the main market.
ii) "once a month - once a year" corrections where the whole market takes a rapid dive in pre-trading or over a couple of hours.
iii) "once in a lifetime - hopefully", i.e. when the market collapses, so do house prices, there's a threat of a run on the pound and no other currency looks particularly safe. This makes it difficult to assess what your assets actually are, let alone what 1% might be.

At the moment I'm quite interested in (ii), because it seems to happen fairly often. I suppose it ought to be ammenable to backtesting a portfolio to see how it fares. Has anyone had a go at this?

Strangelydifferent said:

Hi
I'd read a while ago about using a 1% rule as a guide to limiting individual risks in the context of one's own personal assets.

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Herein lies the problem. I would risk 1% of your account not your worldly goods.

Also depends where you are in your trading career. If you're a fresh-faced newbie then 1% is stupid as you've got (without compounding) 100 goes at getting it right. If you're a seasoned pro, consistently profitable for the last 10 years, then 5% of your worldly goods would improve your income very nicely.

- lets say "personal wealth" means savings, property (that part which isn't owned by the mortgage company!) and maybe other investments in varying degrees of liquidity.

Click to expand...

I am pretty new to this as well, but I would agree with shadowninja (and Alexander Elder) that the amount to be risked should be linked to your trading account, and not to overall assets. And, with that in mind, I would be inclined to risk a rather more daring 2% per trade (per Alexander Elder).

Some thoughts on "personal wealth" follow:

If by "property" you mean the place where you live, I would be give some thought to whether or not this is really an investment. For instance, if you take a big haircut in your CFD account but your property increased in value by a comparable amount over the same period, would you really MEW your house (assuming people still do this, I don't live in the UK any more) so you could keep trading? Or would you take a good look at what had gone wrong in your CFD account?

Similar considerations apply if you have a long only pension fund, which many people will have. And it is little consolation if your pension fund has increased in value if you've just lost the weekend's beer money in your spread betting account, since you can't get at your pension fund until you retire.

As for savings, savings which are for a specific purpose, or as part of an "emergency fund" don't count as investment. Many people around here, especially those who trade full time or have fluctuating income for other reasons, will have an amount of cash or equivalents on hand to tide them through a number of rainy days.

It is only after your "emergency fund" and any savings with a specific intent have been accounted for that the act of saving becomes an investment operation - because you are now making the conscious decision to keep investable assets in cash rather than do something else with it, whatever the "something else" might be (accumulating of unit trusts or mutual funds, speculating in futures based on price action, burying Krugerrands in your garden, opening an ostrich farm, etc.)

I've written quite a bit here, but the thrust of what I'm saying is that despite the proliferation of software packages that offer to calculate your "net worth", this figure is not a useful one for financial planning / risk management.

The 1% / 2% rules should be used to protect your trading account, as the whole point of spending all these hours staring at charts is to generate enough cash so that you don't have to spend time working on a dustcart to pay the mortgage.

Your trading account needs to be seen as an investment by itself, of both time and money. And if you are earning less from trading than you would by putting the money into the building society, you might need to reevaluate how much of your dustcart earnings you should be directing into each of these investments.

shadowninja said:

Herein lies the problem. I would risk 1% of your account not your worldly goods.

Also depends where you are in your trading career. If you're a fresh-faced newbie then 1% is stupid as you've got (without compounding) 100 goes at getting it right. If you're a seasoned pro, consistently profitable for the last 10 years, then 5% of your worldly goods would improve your income very nicely.

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Yes I missed this, you should use the 1% rule in relation to your trading account only, but the way you trade as well as how much experience you have also has an impact on what risk management strategy you ought to adopt.

gacguy said:

I would agree with shadowninja (and Alexander Elder)

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I never thought I'd be put in the same category as Mr Elder. I'm touched.

hi thanks, that had puzzled me - in my original post I used the language I found on the website regarding personal assets, as I could recall it. It wasn't really clear to me at the time what they meant by individual risks. Whatever it was I think it was something quite different to the definition I used above. Maybe they meant trade sizes in shares and even then it does completely miss the point that everyone's circumstances are going to be unique given their mix of experience, other income etc.

shadowninja said:

I would risk 1% of your account

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i would risk 100% of your account, but then again it's your money not mine :clap: