For investors who venture out into the world of investments, it is fundamental to establish and follow a money management strategy, or the asset management rules to be followed to minimize the risks linked to investments.
Although the purpose of money management is to avoid losses, it not the same as risk management. Indeed, the purpose of money management techniques is to expand the investment portfolio to minimize the risk of losing capital.
Money management activities include:
- portfolio formation;
- investment diversification;
- the establishment of stop loss;
- the relationship between the risk and return of every trade.
Difference between Money Management and Risk Management
Therefore, the methods for optimally managing available capital are planned through money management. This set of strategies and techniques is intended to increase profits and protect the investment. People may assume that money management is the same as risk management. However, they are quite different.
Indeed, risk management has a more precise meaning: it consists of the set of techniques that put into practice what was defined in the money management phase, with a view to minimizing risk. In other words, risk management means determining aspects such as entry price, the size of the position and the stop losses (stop loss refers to the price reached at which the investor decides to exit the investment to reduce losses to a minimum as much as possible).
Explained more simply, money management takes place in a prior phase with more strategy and planning related activities. Instead, risk management acts in a subsequent phase in a more operational manner (in any case, in both areas there are elements of strategy and elements of operations, but to different degrees).
Proper money management
The concept at the basis of money management theories is that to minimize losses and maximize profits, only the amount of available capital that can be lost should be invested. As a result, a well-defined strategy is required and it is necessary to avoid investing “randomly”.
But be careful, because applying money management theory does not mean investing without running risks: losses are part of trading activities. However, if we invest with a specific approach, we can aim to minimize them.
To manage capital well, it is necessary to clarify an important concept: you should invest only your savings, your extra money. The sum that can potentially be put at risk should not create difficulties for your personal and household budget. Therefore, investing means first and foremost reflecting.
The quantity of money that you can allow yourself to risk, as a percentage of the capital that can be invested, is called the drawdown. According to experts, it is advisable that the drawdown not exceed 2% for each individual transaction. In general, however, it is always a good idea not to invest more than you are willing to lose and to rely on specialized and professional operators. This is because once the initial capital is lost, it is very difficult to recover it.
Money management: guidelines
The basic purpose of a money management strategy is not to earn, but to defend your capital. This is why it is fundamental to plan and follow a well-defined action plan, following a series of rules, like:
- taking decisions when markets are closed;
- using a protective stop loss, setting it up when the order is executed;
- optimizing losses and increasing profits;
- diversifying assets;
- increasing a security’s exposure;
- using a risk/return ratio based on your own possibilities;
- not being influenced by financial media;
- diversifying trades;
- not risking more than 2% of your capital allocated to investments;
- using real capital only if you are an expert, otherwise relying on an Asset Management Company
Aside from a strategy, it is very important to have the right mindset. In the world of money management, practicality, reasoning, discipline, organization and planning are required, but especially the awareness that real success is attained in the long term.
The sums to be allocated to trading
As has been highlighted, in money management everything revolves around the capital being invested. Determining the minimum capital of your investment activities, therefore, becomes fundamental.
However, it is important to remember that the only key rule in this regard is: never invest more than you are willing to lose.
Therefore, the right sum is calculated on the basis of your own possibilities, without ever putting your savings at risk, and not on the basis of requests made by the broker or the trading platform.
Money management calculation
For those who may have difficulty determining the amount to be invested, there is a money management formula that can help. That is:
C/100 * T = S
where C corresponds to the capital held, T expresses the risk appetite (or the percentage of your capital you are willing to invest) and S is nothing more than the sum that can be invested in the individual transaction. Therefore, entering the numbers corresponding to the investor’s financial situation, you can determine what amount can be invested in the market in that specific case.
For example, if you have capital C of €1,000 and the 2% rule is applied, the amount that can be invested is €20. This is because, when the numbers are plugged into the formula, we have:
1000/100 * 2 = 20
Editor’s note: This article describes money management as a general concept. Although there are common EU laws, regulation may vary from country to country. For further information visit your Country’s Central Bank and Conduct Authority websites, or contact your bank or investment banker.