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There is a very funny video on the web called the difference between porn sex and real sex that makes clever use of vegetables and a female narrator with a proper British accent to blow up most of the porn myths about sex. For example did you know most men are closer to 5 inches rather than 9, most women have NOT had a lesbian “vacation” and that the average sex act lasts a whopping 3 minutes long?
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The video is as subversive as it is entertaining because it shines the light of truth on our very common human fantasies.
When it comes to trading we of course have our version of investment porn that usually takes the form of a post such as this one that I saw on Elite Trader a few days ago,
You hear it over and over: never risk more than 1 percent of your account on any trade.
Others say 2% or 5% and I’ve heard of some risking no more than 0.5%.
But I’ve been aware lately of the risk I face of trading too small.
If I went my trading career only ever risking 0.5% and executed 100 trades per year, assuming a risk:reward of 1:2 and win rate of 0.5 I’d grow my account by 25% annually. If on the other hand I risked 2% using the same strategy I’d grow my account by about 250%.
Over 5 years, assuming I efficiently compounded, at 0.5% risk I’d have a return of 300%. But at 2% risk the return would be more like 10,000%.
By trading too small I’d risk missing out on a significant amount of profit.
According the maths (British spelling) over that 5 year run I’d be likely to experience a losing streak of 9 losses in a row. At 0.5% risk that would be a 4.5% drawdown and at 2% risk an 18% drawdown. The 18% drawdown wouldn’t be fun but it wouldn’t matter in the long run, the return is still 10,000%.
There is just so much wrong with that type of thinking that I don’t even know where to begin. But let’s start with the idea of a losing streak. First and foremost you would be lucky to have a losing streak of only 9 negative trades in a row if you were daytrading the market. It is not uncommon during tough market conditions to experience losing streaks of 20 negative trades. But more importantly drawdowns in trading have nothing to do with losing streaks. The toughest, most insidious drawdowns go like this – win one, lose two, win two, lose three, win two, lose one win one, lose two and so on and so on and so on.
Unless you are an idiot who trades with no stops, drawdowns in speculative markets are not the result of one or two badly placed trades, but rather a death by a thousand small cuts. Indeed even the most successful day trading systems spend the majority of their time basically breaking even and make most of their gains in equity over only 10%-20% of the trading days. So your chances of consistently making 0.5% every day and compounding that to some astounding 100 fold gain in equity are virtually nil.
Yet like an everlasting erection, the fantasy of 0% to 10,000% gains in a matter of several years is the investment porn that is sold to traders on a daily basis. As we get older we all become better at distinguishing between fantasy and reality and most of us understand quite well that life is not a porn movie. But when it comes to trading, too many of us still fall for the dream of making millions from nothing.