Trading, How Much capital to put at Risk?

Many have an approach to trading and investments at the limit of gambling, while very few adopt a more schematic and prudent approach.

But how much capital do you have to risk to trade? Is there an exact formula to calculate it? Obviously the answer is: “it depends” on many factors, both subjective and objective, on personal goals and on investment objectives and, above all, on our psychological approach to the world of financial markets.

As you can see, we have taken many factors into consideration and all of them determine that threshold of capital to put at risk if we want to trade and/or invest. Let’s see together the fundamental aspects to take into consideration.

Why Invest or Trade?

The first question we must ask ourselves is: “Why do I want to trade?”, “Why do I want to invest in financial markets?”.

This aspect is fundamental in that de facto excludes the instinctive mechanism bordering on the ludopathic of wanting to demonstrate that we are capable of operating on the financial markets. The answer to this question, in most cases, would be "because I want to make money", so trivial and obvious that it would require a further question, namely "why do you want to make money on the financial markets?".

The outcome of the answer is crucial in understanding many things about our future in the investment world. There are those who will say that they want to operate on the financial markets because it is the fastest way to make money in a short time (true but difficult), or there will be those who answer saying they want to invest money to have capital increased over the next 20 years, or whoever says they want to seriously learn how to invest or make trading a real job. In short, as you can see, everyone’s needs are extremely subjective and the more the answer will be serious and precise, i.e. with a well-defined goal, the more likely it is to cause disasters in the long run.

Unfortunately, many think that trading or investing is a game, that the financial markets are a huge betting house for people who have a huge amount of capital. In reality this is not the case, on the contrary, the financial market is a highly meritocratic environment, where high specialization corresponds to high salaries and great financial results.

Age and time horizon

As far as investments are concerned, it is logical that younger age corresponds to greater risk and major age corresponds to lower risk. For example, a 20-year-old boy is much more likely to be driven to begin a career as a quantitative trader than a 70-year-old gentleman.

Usually, both in the trading and investment fields, a young person is more inclined to an investment in risk markets, compared to a very old person. This happens because a greater amount of time allows us to manage a greater amount of risks assumed, therefore the dose of risk that a person can assume is all the higher the younger he is. Going forward in time, there is a need to preserve the accumulated capital. This is also a rule that usually applies within financial advice, i.e. when building a portfolio where the advisor first evaluates the client’s objectives, and then builds a portfolio of financial instruments suitable.

Younger clients have access to more instruments while older clients, unless explicitly requested by the client, have access to low risk instruments only.

Trade or invest?

It all depends on your life goals. We could find a 25-year-old young man who wants to learn the trader’s profession, therefore he will have to invest part of his capital in training in the field, with courses, coaching, direct experience on the market which leads to inevitable losses, in short, he will have to take into account that there will be costs to face as in any trade that one wants to learn. Equally we could find a 25-year-old young man who is not interested in trading but wants to start building his own securities portfolio for future years, perhaps to buy a house or a nice car, to find himself with a good liquidity in the years to come, in short, for a specific objective. As you can see two equal profiles but with different objectives. However, being two young profiles, their risk tolerance is high but obviously anyone who wants to be a trader will have to face higher costs, and therefore will have to take into account a higher risk.

As regards a profile with an age that goes from 40 years up, the risk decreases, i.e. if he wants to learn how to be a trader, or invest part of the capital, he will still have to risk less as a percentage on his capital, compared to the same profile of twenty-five year olds. While a young man is willing to lose even 50% of his entire capital to learn how to trade, a forty-year-old will risk a maximum of 20% or even less. That of age, mind you, is just an example to make you understand that with advancing age, the propensity to protect one’s own capital must increase.

Perception of risk

Beyond age, there is a very important component that can be traced back to a cognitive bias that concerns our perception of risk, or rather, our perception of possible pain in the face of a financial loss .

Many people, especially those who approach trading, see and face this problem right away. When asked "how much risk is it involved into this operation?", they usually answer with a figure which, once manifested as a loss, generates a sort of psychic pain and sometimes physical (if the sum is significant). This thing happens because we don’t actually know what it means to lose money on the financial markets, it’s a completely new experience that has nothing to do with betting, quite the contrary. In practice, the only thing to do in these cases is decrease our hypothetical risk threshold by a lot. For example, if we imagine that we can bear a loss of 100, this effective loss will have to be decreased until we find that threshold that makes us feel comfortable.

Risk management and money management

From an operational point of view, these concepts are enclosed in the disciplines of risk management and money management, concepts that are best extrapolated in the path needed to trade. Obviously these risks are well calculated and are usually measured on the basis of the capital available, by means of percentage calculations and not by means of absolute values.

Original article published on Money.it Italy 2023-01-03 08:57:00. Original title: Trading, quanto capitale rischiare?