The Holy Grail of successful investing is risk management. Once I had a market timing system that I was happy with, I realised that without a sound risk management system, I was losing more money than I was making.

In hedge fund vernacular, it is called “eating like a bird and shitting like an elephant”. A little extreme, but you get the drift. And it was not until I understood how to put together a risk management system, that I was able to get consistent returns from my investments.

The risk management system that we will create will work with your market timing strategy and will be linked to the size of your capital.

It will ensure that either you have a good risk to reward ratio (the per rupee amount you stand to make for every rupee that you risk) or a high success ratio.

Let’s look at the Risk-Reward ratio and position sizing in detail

Holy Grail Part 1: Risk-Reward Ratio

The risk to reward ratio (R:R) measures the amount of money you stand to make for every rupee that you risk.

It works something like this:

Let’s say you decide to buy HDFC Bank at 1,000 rupees.

That is your entry price – E.

Let’s say your market timing system sets your stop loss at 980 rupees. If the price goes beyond 980 rupees, you no longer want to be in the trade. So, in this case, your risk, in rupee terms, is 20 rupees.

Now, if the system says that you must book your profit at 1,060 rupees, the profit potential of your investment is 60 rupees.

That makes your R:R at 60 divided by 20 or 3:1!

This means that if you are right even 50% of the time, you will make money. Let’s see how that works.

Total returns: 80 rupees

Success Ratio: 50%               Risk-Reward Ratio: 3:1

But this is still not the entire picture. To control our risk, we need to understand how position sizing works.

Holy Grail Part 2: Position Sizing

The Industry maximum for per trade risk is 2% of capital. On average 1% is applied.

This is how it works:

Let’s say you have a capital of 1 lakh rupees. 1% of that is 1,000.

That is the amount of risk you will take per trade.

So how do we apply our allotted risk to our trade?

By controlling the position size of course!

This means, if we apply this to the above scenario of the HDFC Bank trade, a 20 rupee risk will mean that we can take a position size of 1,000 (our risk amount) divided by the per rupee risk of 20 rupees. Giving us a position size of 50 units.

This means that if the trade goes against you, you stand to lose a pre-decided amount of 1,000 rupees.

This is in stark contrast to what a lay investor will do.

Once he has decided on the HDFC Bank trade, he is 100% sure that the trade will work in his favor.

If you are shaking your head, you are absolutely right. That is never the case.

But since the average investor is so sure of his trade, he puts all his capital on that one trade. That means an average investor would have a position size of 1 lakhs rupees (his capital amount) divided by the price of the chosen stock, 1,000 rupees in this case. Or 100 shares.

This has two implications.

Firstly, in this situation, and assuming he does put in a stop loss, his loss increases to 100 shares times 20 (the per rupee risk amount), 2,000 rupees. Or 2% of his capital.

But it gets worst still. If the price of the stock is not 1,000 but, let’s say 100 rupees, his position size increases to 1 lakh divided by 100 or 1,000 units. Allowing him to lose 20,000 rupees or 20% of his capital on one single trade!

This can quickly increase to 40% if he is like most investors and invests without a stop loss.

I promised you the holy grail of investing. And this is it! As a core part of your investment plan you will control your risk by linking the positions of every investment to the pre-decided risk level.

This is how it will work

Now if you have a favorable risk-reward ratio of say 3:1

Then you have to be right only 50% of the time. This is how it will work.

Let’s say you make 20 investments in a year. 50% of which go in your favour. So you have 10 winners giving you a total of 10 into 3 into 1,000 or 30,000 rupees. Likewise, the ones that don’t work, will mean you lose 10 into 1 into 1,000 or 10,000 rupees. Giving you a net return of 20,000 rupees or 20% return on your capital.

While this may not sound like a lot, if you understand the dynamics of the system, all you now need to do is increase the number of your trades, or increase your per-trade risk amount.

More importantly, these are returns you can make on a regular basis.

This is how the professionals trade. They don’t leave things to chance and are more interested in making regular, consistent profits rather than one-off multi-baggers.

Make sure you incorporate a complete risk management system in your trading plan.