The coin toss experiment

So, I designed an experiment with my niece to see the impact risk management has on a trading system. To ensure the odds are on her favor, I gave her a 1:2 risk: reward system over 30 tosses.

She had to guess on the landing on the flip of coin, wining twice as much as she bet when she guessed right, and only loosing as much as she bet when she guessed wrong. With 50% probability of winning on each toss, over 30 coin tosses she should be profitable.

Without any knowledge on risk management, on her first try her R1000 ran out after 19 tosses. She was wild with her bets risking on average 39% of her account balance on every toss.

To make interesting, I promised her she was going to keep any profits she made on a R100 to see if she would risk differently if there as really money on the line. She was slightly luckier and lasted more for the entire 30 tosses but unfortunately she was 86% down, this time risking on average 33% real money on the line didn’t seem to phase her.

I then took her trades and changed the bet size to see what was going to happen if she only risked 2% of her account on every flip with same luck or lack there of. She was going to end up with 25.34% if she only risked 2% per toss

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What I noticed the patterns in thought and goals were very similar to mine when I started trading in the way she was sizing her bets, with her eyes firmly on how much she stands to make on every toss.

In both instances she flipped between making a lot of money, trying to get back, and survival mode. Not once did she realize that she had a great system and the problem was her thinking she knew what was going to happen next. If she manage ger risk well not only was she going to preserve her initial capital but she stood a better chance of making profit with smaller bets. She traded similar to all novice traders.

Lesson

 A good system with a statistical positive expectancy, will not save you from a bad money management.

Dr Alexander Elder in his book “trading for a living”. Says the goal is to trade well, and not necessarily to make money. Money come as a byproduct of trading well.

The goal of a successful trader in priority are

  1. Preserve capital
  2. Steady growth of Capital
  3. Make large profits

Most traders, certainly myself included put the 3rd goal first and completely disregard goal 1 & 2 or often not even aware that they exist.

Most traders are trading like my niece, even with a good system with odds in their favor, their failure is inventible purely on poor money management and lack of discipline.

Lesson, if I focus on rule 1 & 2 and just trade well, the odd over the long term will be in my favor.

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Thank you loads

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