Managing Editor’s Note: Today, we’re handing the reins over to colleague Larry Benedict – a market wizard and legendary hedge fund manager.
Today, he’ll share with you one of his most crucial risk management strategies… one that preserves capital and prevents a losing year for trades…
Here’s Larry with the insights…
Most folks don’t like uncertainty.
We’re much more comfortable when we know what’s going on. Then we can set our sights and plan accordingly.
That trait can become a massive hurdle in the financial markets, though…
Shocks come along all the time. And many are unpredictable.
We saw that on August 5. The unwinding of the Japanese yen “carry trade” set off a wave of selling around the world.
And I’ve seen plenty of other shocks throughout my 40-year career…
At the beginning of my career, there was the 1987 crash. Then I saw the bursting of the dot-com bubble and the financial crisis of 2008. And in 2020, we were hit with COVID.
All of these downturns caused huge damage to investors and threw global markets off-balance.
But by understanding one simple premise, I’ve been able to successfully navigate these shocks and countless others that have come my way…
Futile Predictions
Over my decades of trading (including my time running a multimillion-dollar hedge fund), I learned you can’t avoid market shocks.
You need to accept that they’re going to come.
And no two shocks start the same way. So trying to predict the next shock is a futile exercise.
There are too many moving parts. The crosscurrents across global markets and the major economies are too complex.
And most of the dire warnings of imminent collapse vanish into thin air.
With that all in mind, the best way to navigate shocks is based on what we can actually control.
It’s simple: Manage your risk.
By fastidiously controlling risk, it doesn’t matter how big a shock might be. It won’t be able to put you out of the game…
Trade Size Matters
The first rule I applied to my own trading was to only allocate a small portion of my account to any one trade.
It’s a case of mathematics.
If you only allocate 2–3% of your trading capital to any one position, then no trade can break you. That’s true even if the market crashes.
Even if that trade goes all the way to zero, you’ve still got 97–98% of your account intact.
I learned this the hard way after blowing up my trading account several times early in my career.
But from those harsh lessons, I took this another step further…
If I was down 2–2.5% in any month across my entire portfolio, I’d liquidate all of my trades and start over fresh the next day.
And I’d reduce the size of my positions. I’d cut my trading size in half. If that didn’t work, I’d cut it in half again.
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Only when I started making money consistently would I start to increase my trade size again.
Doing this enabled me to rack up 20 years without a losing year during my hedge fund days.
And ultimately, it led to Jack Schwager featuring me in his book Hedge Fund Market Wizards in the chapter just after Ray Dalio – the billionaire founder of Bridgewater Associates. Schwager noticed how critical my risk management skills were to my success.
Rather than trying to predict the future, I learned to manage the one thing I could control: my risk.
That enabled me to withstand all the inevitable market shocks that came.
Like we saw on August 5, shocks can come out of nowhere.
But if you have strong risk management principles and steadfastly stick to them, it will ensure you come out swinging on the other end.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict