What is Risk Management? You want to be the rich statistician and NOT the gambler.

What is Risk Management?

This section is one of the most important sections you will ever read about trading.

Why is it important? Well, we are in the business of making money, and in order to make money we have to learn how to manage risk (potential losses).

Ironically, this is one of the most overlooked areas in trading. Many traders are just anxious to get right into trading with no regard for their total account size.

They simply determine how much they can stomach to lose in a single trade and hit the "trade" button. There's a term for this type of investing....it's called...

GAMBLING!

When you trade without money management rules, you are in fact gambling.
You are not looking at the long term return on your investment. Instead you are only looking for that "jackpot".

Money management rules will not only protect you but they can make you very profitable in the long run. If you don't believe us, and you think that "gambling" is the way to get rich, then consider this example:

People go to Las Vegas all the time to gamble their money in hopes of winning a big jackpot, and in fact, many people do win.

So how in the world are casinos still making money if many individuals are winning jackpots?

The answer is that while even though people win jackpots, in the long run, casinos are still profitable because they rake in more money from the people that don't win. That is where the term "the house always wins" comes from.

The truth is that casinos are just very rich statisticians. They know that in the long run, they will be the ones making the money--not the gamblers.

Even if Joe Schmoe wins $100,000 jackpot in a slot machine, the casinos know that there will be hundreds of other gamblers who WON'T win that jackpot and the money will go right back in their pockets.

This is a classic example of how statisticians make money over gamblers. Even though both lose money, the statistician, or casino in this case, knows how to control its losses. Essentially, this is how money management works. If you learn how to control your losses, you will have a chance at being profitable.

In the end, Forex trading is a numbers game, meaning you have to tilt every little factor in your favor as much as you can. In casinos, the house edge is sometimes only 5% above that of the player. But that 5% is the difference between being a winner and being a loser.

You want to be the rich statistician and NOT the gambler because, in the long run, you want to "always be the winner."

So how do you become this rich statistician instead of a loser?

Read more: 

http://www.babypips.com/school/what-is-risk-management.html#ixzz1ebTZDg9e

Failure of a 'foolproof' gambling system

Calculating the true odds is quite complicated, but once every 28 or so times you begin the betting sequence on a 37-number wheel, you should expect to lose your entire capital base. I've dubbed this ''the Fairstar principle'':


Risk & reward

Consistent small wins can disguise the true relationship between risk and reward. 

A lack of appreciation of this principle has cost investors billions over the past three years. Funds run by the likes of Basis Capital, as well as the implosion of RAMS Home Loans can be linked back to the Fairstar principle.

Why? Because the business models were based on strategies that involved regular small wins (and, in the case of the funds, accompanying performance fees) until, one day, the unlikely event (or ''black swan'') turns up and calls ''time'' on the party.


http://www.smh.com.au/business/failure-of-a-foolproof-gambling-system-20100428-trch.html



Here is a good comment:

Any roulette system which starts with observing the behaviour of the wheel and when some particular pattern is observed, such as the "three consecutive same colours" commences operation, supposes that the wheel (or the ball) has a memory, which it does not.

Each spin is an event in itself, and what happened before is of no matter.

There could have been 100 consecutive reds and on the next spin red and black still have an exactly equal chance of occurring, assuming that the wheel is not rigged in some way.

"Common sense" might suggest otherwise, and that after 100 reds black MUST be overdue but common sense isn't common at all!

Doubling up to chase losses is a very risky business, if Bill Gates and Warren Buffett tossed a coin for a dollar a time and went "double or quits" after each loss one would eventually bankrupt the other.

And it would only take something in the order of 36 consecutive "double ups" for it to happen.

In fact, this is why casinos have table limits. Many people think they exist to protect the punter, but in fact they are to protect the casino from a punter with sufficient resources and nerves from continually doubling up until he wins.

If more punters studied elementary probability they would lose a lot less.

Reformed Gambler | Canberra - April 28, 2010, 2:01PM

To quote Albert Einstein, who knew a thing or two about maths: "The only way to win in Roulette is to steal from the croupier when he is not looking."

Reformed Gambler | Canberra - April 28, 2010, 5:58PM

Read also:
Behavioral Finance: Key Concepts - Gambler's Fallacy

An intelligent and patient investor has a big advantage over the “gambler”-investor.

A lot of people like to argue that the rate of return you can expect from an investment is directly related to the amount of risk you take on. The more risk you have, the greater the potential return - but also the greater risk if you suddenly need to pull out your money.

I’ve always felt that this is a very limited view of things and that it ignores the effort and intelligence of the investor. An investor who can invest a lot of time studying the market and specific investments and can apply cool reasoning and behavior to his or her investments can get a better return than an investor who just wants to stick his or her money somewhere.

Take index funds, for example. Stock index funds are made up of all of the stocks that meet a certain criteria. If you buy into an index fund, it’ll essentially do as well as the average of all of those stocks. That actually also lowers your risk a fair amount because you’re not tied to the ups and downs of a specific company.

For an investor with limited time to research and understand specific investments - such as me - that’s a great way to invest. However, I know that if I had adequate time to actually study the market and played it cool, I could often (not always, but often) pick specific stocks that would beat this return.

Why don’t I do that? With the amount of money I have to invest (relatively small) and the time it would take to actually do the research and pick the investments (relatively large), it’s not a cost-effective use of my time. Give me index funds or give me death!

This is much the same logic that this chapter provides. Graham also buys into the idea that an intelligent and patient investor has a big advantage over the “gambler”-investor.


http://www.thesimpledollar.com/2008/11/07/the-intelligent-investor-general-portfolio-policy-for-the-defensive-investor/

Behavioural Finance

Behavioral Finance

By Albert Phung

Whether it's mental accounting, irrelevant anchoring or just following the herd, chances are we've all been guilty of at least some of the biases and irrational behavior highlighted in this tutorial. Now that you can identify some of the biases, it's time to apply that knowledge to your own investing and if need be take corrective action. Hopefully, your future financial decisions will be a bit more rational and lot more lucrative as well.

Here is a summary:

• Conventional finance is based on the theories which describe people for the most part behave logically and rationally. People started to question this point of view as there have been anomalies, which are events that conventional finance has a difficult time in explaining.
  
• Three of the biggest contributors to the field are psychologists, Drs. Daniel Kahneman and Amos Tversky, and economist, Richard Thaler.
  
• The concept of anchoring draws upon the tendency for us to attach or "anchor" our thoughts around a reference point despite the fact that it may not have any logical relevance to the decision at hand.
  
• Mental accounting refers to the tendency for people to divide their money into separate accounts based on criteria like the source and intent for the money. Furthermore, the importance of the funds in each account also varies depending upon the money's source and intent.
  
• Seeing is not necessarily believing as we also have confirmation and hindsight biases. Confirmation bias refers to how people tend to more attentive towards new information that confirms their own preconceived options about a subject. The hindsight bias represents how people believe that after the fact, the occurrence of an event was completely obvious.
  
• The gambler's fallacy refers to an incorrect interpretation of statistics where someone believes that the occurrence of a random independent event would somehow cause another random independent event less likely to happen.
  
• Herd behavior represents the preference for individuals to mimic the behaviors or actions of a larger sized group.
  
• Overconfidence represents the tendency for an investor to overestimate his or her ability in performing some action/task.
  
• Overreaction occurs when one reacts to a piece of news in a way that is greater than actual impact of the news.
  
• Prospect theory refers to an idea created by Drs. Kahneman and Tversky that essentially determined that people do not encode equal levels of joy and pain to the same effect. The average individuals tend to be more loss sensitive (in the sense that a he/she will feel more pain in receiving a loss compared to the amount of joy felt from receiving an equal amount of gain).
  

Table of Contents
1) Behavioral Finance: Introduction
2) Behavioral Finance: Background
3) Behavioral Finance: Anomalies
4) Behavioral Finance: Key Concepts - Anchoring
5) Behavioral Finance: Key Concepts - Mental Accounting
6) Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
7) Behavioral Finance: Key Concepts - Gambler's Fallacy
8) Behavioral Finance: Key Concepts - Herd Behavior
9) Behavioral Finance: Key Concepts - Overconfidence
10) Behavioral Finance: Key Concepts - Overreaction and Availability Bias
11) Behavioral Finance: Key Concepts - Prospect Theory
12) Behavioral Finance: Conclusion