The Risk of Ruin: Survive today for to conquer future
Enjoying the pain- Adversity
This is perhaps only rule ever change in a stock market, the market will do everything to disappoint you and you should never ignore this. It creates obstacles, confusion, complexity which makes easy things extremely difficult. It forces you to doubt every move you make in market.
You can say it’s the discipline market expects from you, with a stronger discipline money transfer from weaker hands to stronger hands. Discipline can be partly overcome by good behavioural finance also money management! One of the key aspect of money management to trade with zero risk of ruin at any point of time.
What is Risk of Ruin?
It indicates the chance you will go bust, unable to trade after certain capital losses. So, this should become our first priority as risk management. It’s a concept from statistics, likelihood you will incur such a huge loss you would stop trading. It may not mean losing entire capital or called bankrupt. Depending on your risk tolerance your point of ruin can be 50% even. Example my point of Ruin is 35% of available capital for investing and trading.
The first step to avoid ruin is to calculate the probability of reaching ruin. If the probability is on higher side you must work towards to reduce it to an acceptable level. This itself demonstrates a significant step toward in survival in trading. In short higher capital you risk in a stock higher the chance of being wiped out.
Lets come to the formula for Risk of Ruin
((1-(W-L)) DIVIDED BY ((1+(W-L)) TO THE POWER ‘U’
W is probability of winning
L is probability of losing
U is number of attempts you are planning to allocate available capital (say 1 lac in account, I want to invest 10000 each in 10 stocks once. Then U becomes 10).
Let us not waste time behind formula. Plenty of calculators are available free online. Let us simulate results for better understanding:
If you see at probability of winning 50%, with equal amount of winner/loser (this means when you win average amount is 10000, when you lose also 10000), number of attempts 10 (10% risk), 70% is tolerance level (at 50% capital loss I will stop investing). The risk of ruin is 100%, a very high probability. YOU WILL BUST HERE, TODAY OR TOMORROW IS JUST A WAITING TIME!
Now lets change number of attempts to 20 , Risk of ruin is 100% still. Even with 1% it remains 100%. You know why because with equal probability between number of winners and amount you will never make money.
For better pastures lets change probability of winning to 60%, and winner/loser to 2:1. With 10% risk per attempt Risk of ruin fall down to 4.46%. When you make 2% risk per attempt it becomes zero percent.
Grave it in platinum, NEVER EVER INVEST OR TRADE AT ANY POINT OF TIME WHEN RISK OF RUIN IS MORE THAN ZERO PERCENTAGE. Yes you heard it right, ZERO; let me repeat a BIG ZERO. Not even 0.2% or 0.5%. Forget 2% even!
Fine, let us move to understand what is this conveying and how do we understand attributes behind this.
First we must understand even with zero percent risk of ruin we can still go bust. Because zero risk of ruin does not guarantee accuracy of win or even the amount of winner against loser. So zero percent risk of ruin does not guarantee a deterioration in methodology will protect you. But method remains steady it will prevent you getting ruined. At the end statistical measure depends on various inputs, they are all dependent on each other. Either increase amount of winner or increase of percentage of winners. Message it’s a combo plan not stand alone plan.
Obviously then how do we reduce risk of ruin. Of course we need to risk a smaller amount of capital, if it’s too high we will be knocked out. This is where money management should begin, successful investing is about survival and good risk management.
Let me summarise one more time how to reduce risk of ruin:
- Reduce the capital allocation per attempt
- Increase your winning percentage
- Increase pay off- average winner higher than average loser.
Do let me know your risk of ruin if you can calculate, this is mine on 09 Dec 2017
Accuracy of winning: 41%
Average winner to loser: 3.38
Risk of Ruin: Zero
Story is just beginning, lots to cover. Risk of ruin without expectancy, methodology and position size is meaningless. They are all part of single framework.
Lets continue with holy grail of money management; next may be how expectancy is linked to risk of ruin in detail. Sometime we will move to entry method. But trust me the challenge is to find a good risk management and money management customised to your requirement. Stock name won’t resolve 10% of problem even, I am still learning hard way.