What is ‘Money Management’
Money management is the process of budgeting, saving, investing, spending or otherwise in overseeing the cash usage of an individual or group. The predominant use of the phrase in financial markets is that of an investment professional making investment decisions for large pools of funds, such as mutual funds or pension plans.
Also referred to as “investment management” and/or “portfolio management”.
BREAKING DOWN ‘Money Management’
While the term is usually used in reference to professional money managers, everyone practices some form of investment management with their personal finances. There are a wide range of money management services, from the operation of passively-managed mutual funds with low fees to in-depth estate planning and consulting.
Trading and investment
Money management is used in investment management and deals with the question of how much risk a decision maker should take in situations where uncertainty is present. More precisely what percentage or what part of the decision maker’s wealth should be put into risk in order to maximize the decision maker’s utility function.
Money management can mean gaining greater control over outgoings and in-comings, both in personal and business perspective. Greater money management can be achieved by establishing budgets and analyzing costs and income etc.
In stock and futures trading, money management plays an important role in every success of a trading system. This is closely related with trading expectancy:
“Expectancy” which is the average amount you can expect to win or lose per dollar at risk. Mathematically:
Expectancy = (Trading system Winning probability * Average Win) – (Trading system losing probability * Average Loss)
So for example even if a trading system has 60% losing probability and only 40% winning of all trades, using money management a trader can set his average win substantially higher compared to his average loss in order to produce a profitable trading system. If he set his average win at around $400 per trade (this can be done using proper exit strategy) and managing/limiting the losses to around $100 per trade; the expectancy is around:
Expectancy = (Trading system Winning probability * Average Win) – (Trading system losing probability * Average Loss) Expectancy = (0.4 x 400) – (0.6 x 100)=$160 – $60 = $100 net average profit per trade (of course commissions are not included in the computations).
Therefore the key to successful money management is maximizing every winning trades and minimizing losses (regardless whether you have winning or losing trading system, such as %Loss probability > %Win probability).
So, in short, Money Management is a very useful concept that could help an individual trader or investor to stay in the game, profitably.