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Thursday, November 15, 2007

Money Management: Accuracy Rate

Accuracy describes just that. How accurate are you with your market calls? 30% accurate? 50% accurate? 80% accurate?

I don't think I have ever seen a more overhyped, yet necessary part of money management stressed. 'Systems' and knowing ones accuracy rates are vital for proper money management. And let's face it, we'd all like to be right 90% of the time, as to market calls.

Yet small time traders and speculators act as if Accuracy rate is the end all be-all of trading. As if a person had an 85% accuracy rate, that would guarantee him to be profitable when trading and investing.

Nothing could be further from the truth.

It's an idea which is wrong. False. Untrue. And downright dangerous to believe. The reason people focus on accuracy, is because they get everything in reverse, when it comes to their trading and investing. It comes about, is because people look to the system that sells signal first, and money management principles second. If they look to money management at all. Want proof? Do a Google Search for "Market Picks" or "Winning Signals". Then try to find one, just ONE of them that teaches about money management.

The system for giving you signals comes second to your money management strategy, not the other way around!

In fact, an investor and/or trader can be right only 50% of the time, and still be profitable if his money management strategy is set correctly. An investor? Can generally stand an even lower accuracy rate, and still be highly profitable. This is because it generally takes less capital, less leverage to invest in the stock market, than it does to trade stocks, or trade futures and commodities.

Regardless, want proof? Simple test.

You have a trader who is right 50% of the time. Let's say every trade he engages in, he risks 1 dollar, to try to make 4. He actually averages a ratio, in practice of 1 risk to 3.5 dollars. What does the math tell us? That he is a profitable trader.

SYSTEM A:
TRADE 1: Loss - $1
TRADE 2: Profit - $3.2
TRADE 3: Loss - $1
TRADE 4: Profit - $3.2
TRADE 5: Loss - $1
TRADE 6: Loss - $1
TRADE 7: Profit - $3.2
TRADE 8: Loss - $1
TRADE 9: Profit - $3.2
TRADE 10: Profit - $3.2

5 Losses. 5 Wins. Total Lost: $5.00. Total Wins: $16.00.

Now lets take the 80% accurate trader, who doesn't pay attention to money management principles or have a money management strategy.

SYSTEM B:
TRADE 1: Profit - $1
TRADE 2: Profit - $3.2
TRADE 3: Profit - $1
TRADE 4: Profit - $3.2
TRADE 5: Loss - $10
TRADE 6: Profit- $1
TRADE 7: Profit - $3.2
TRADE 8: Loss - $7
TRADE 9: Profit - $1
TRADE 10: Profit - $1

2 Losses. 8 Wins. Total Lost: $17.00. Total Wins: $14.60

System A was 50% accurate. System B was 80% accurate. But which system made money?

Now do we see why risk / reward ratios, both projected and actual are so important? Why accuracy isn't as important as money management? Why it's important to have an adequately funded trading account, and only risk 3%?

Now that I'm done debunking the "Accuracy" overhype? Let me stress how important Accuracy is to your money management strategy overall Smile

It's important to view your Money management strategy as a math equation. You need all of the variables to work together, in order for you to be a success, right? Accuracy is one of those equations, and it is important to know both what your accuracy rate is, and how it fits in with the rest of your money management strategy. Let's face it, an 80% signal system would be good, as long as it doesn't call for large losses. Unfortunately, by the very nature of some systems and how they work? That's exactly what happens. When they lose, they lose big. Regardless, I won't digress into that speech again.

One must keep track, and know ones accuracy rate, in order to know how to work the rest of your money management strategy. It's one of the variables. Mind you, it's only ONE of the variables, but a variable nonetheless.

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