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Risk of Ruin. An Unpleasant Topic for Traders

This post recently appeared at OptionsZone.com, where I am a contributor.  Take a look at Options Zone – you will discover options articles of interest.

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For some, investing is a necessary evil.  Such investors don't want to be bothered, and often hire professionals to handle their investment decisions.  Others love the idea of making trades, and if they encounter a winning streak, may seriously consider the idea of quitting their jobs and becoming full-time traders.  Trading is one of those enticing, glamorous careers.  The idea of being self-employed, taking vacations whenever you want, earning tons of money – it all sounds like a dream come true.

It is a dream, but the truth is unpleasant.  The average income for people who try to become full-time traders in an attempt to support themselves and their families is less than zero.  In other words, it's not that they don't make enough money to survive as a trader.  It's that they don't make any money.  The vast majority are forced to give up the dream and go back to the real world. 

We don't see people trying to practice law or medicine without the proper education, training and licenses, yet many individual investors believe it cannot be difficult to trade for a living.

There are many reasons why the majority cannot succeed as traders.  The obvious is that not everyone has the required skills.  It takes an education, the ability to understand what's required, and a special skill set to be a surgeon, professional athlete, or novelist.  The profession of trading has similar entry points.  The problem is that few believe that to be true. 

They put together a small pile of cash, make some trades and are disappointed when they realize how difficult it is.  Making money is tough enough, but when trading expenses are added to the picture, the burden is too great and profits are not achievable. 

And for those who do well, i.e., they do better than average and eke out a small profit – they never consider that choosing the wrong broker – one with high fees – may be more than enough to make frequent trading unprofitable.  Or perhaps they go the other route and sacrifice good trade execution for low rates.  Poor decisions along those lines may be enough to sink a trading career.

Trading looks easy.  You buy, and then sell at a higher price.  Or perhaps you sell short, and then buy at a lower price.  What's so difficult about that?  Those TV ads of the 1990s technology bubble convinced many that it's a cinch to get rich in a hurry.

Today's post is not about the requirements per se; it's about one simple idea that is virtually ignored by both professional and amateur traders/investors: Statistics and probabilities. 

Something as innocuous as being unfamiliar with statistics can make all the difference. Few traders have any understanding of this mundane mathematical science.  And those who may have some passing knowledge fail to recognize how vital it is to pay attention to statistics and the lessons they teach. 

Option traders may talk about probability of earning a profit for a given trade, or recognize the probability that a specific option will be in the money when expiration arrives.  However, the majority have never paid any attention to, or possibly never heard about, one vital statistic:  The Risk of Ruin.

I've published a list of my four important trading rules.  At the head of the list is the simple command: Don't go broke.  The problem is that I am guilty of not delving into how the trader avoids going broke.  Sure I talk about managing risk and being careful with position size, but there's more to it.  It's important to understand the risk of ruin.

Definition

The risk of ruin, sometimes referred to as 'gambler's ruin' is the probability of losing your entire investment account.  It's also the probability of losing so much of the account that there is too little remaining to allow you to continue trading.

There is a formula, and thus a calculator, that can be used to quantify the investor's risk of ruin.  Because gambling and investing/trading have much in common, the mathematics of the calculation are the same.  The key for investors is to translate the calculator inputs from gambler's language to investor's language.  A trusted friend has done that for us.  See Dr. Brett's description of the risk of ruin, including a link to a calculator and examples of how small changes in your approach can make a huge difference in the probability of losing everything.

This risk of ruin applies to retirees.  If you are invested and withdraw a portion of your assets every year, there is a chance of outliving your money.  That's certainly equivalent to blowing a trading account in that it's something that must be avoided.

It's important to pay attention to risk of ruin (RoR), but as mentioned previously, most traders have no idea that such a concept exists, let alone that it can be measured.


Philosophy

RoR calculators are designed for people who take frequent risk-taking chances.  They are appropriate for a day trader, or gambler, not for someone who travels to Las Vegas once every three years. 

Applying the numbers to investors with longer time frames is more difficult.  But, if you understand the concept, you can find probabilities that apply to your situation.

Subtle-looking changes in your trading style can make a huge difference in the probability of ruin.  The first item in the list is often the killer.  Trading with too little money makes it difficult to succeed.

The following increase the risk of ruin:

  • The size of your initial bankroll decreases
  • Trade size increases
  • Trade frequency increases
  • Your win rate decreases; you begin to win less often
  • Your 'opponent' has more money than you (in other words, his/her risk of ruin is much smaller than yours)
  • Your 'edge' decreases, and your average profit becomes smaller
  • Emotions begin to affect decisions

One reason so many trader wannabes are forced out of the game is that their initial stake (account size) is too small.  Another is that they trade too often, especially when attempting to recover losses.  When investing, your opponent can be considered to be the vast sum of money collectively owned by 'everyone else.'  There's nothing you can do about that negative feature, but you can be aware of it.

If you begin trading with emotion instead of developing a plan, your edge decreases.  That's a very quick path to losing it all.

Bottom Line

Understanding the probability of going broke is a major requirement of the wannabe trader.  I certainly wish I had been aware of these statistics earlier in my career. 

How do you use the numbers when you get them?  I have no answer to that.  If you are trading with your life savings or retirement nest egg, would you be glad to have a risk of ruin that's 'only' 3%?  Or would you consider that to be far more risk than you can afford?

One way to use the numbers is to see how the effect of position size (money at risk) makes a large difference in that risk of ruin.  However you choose to use this statistic, my suggestion is that ignoring it is not viable if you plan to have a long career as a trader.

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