HOW YOUR SURVIVAL IS THE GREATEST ASSET YOU HAVE
The financial markets are one of the few places where every aspect of behavior, valuation, and price movement is broken down into quantifiable terms. There are ratios to measure valuations. There are ratios to measure the ratios of valuation. There are a myriad of statistics to measure how investors are feeling on a particular day, week or month. There are thousands of measures of price and even more measures to measure the various measures. It's a world dominated by numbers and the interpretation of the values that those numbers have on a minute by minute basis.
There is a number that makes its home right in the center of this universe of values and ratios that is rarely discussed or even mentioned. In fact, for all the years I have been involved in finance I haven't heard it mentioned at all. This is despite the fact that this number may be the most important number of all.
What is it? I call it the survival quotient.
The fact that you are in the markets and freely available to speculate with the capital you have at hand has a value. The value comes in the form of opportunity. When your capital diminishes significantly, so does your survival quotient. The moment you cease speculation in the markets due to a disastrous loss, your survival quotient will go to zero. Meaning that all of the opportunity you had and the potential that came with it to generate X% over your lifetime disappears.
The fact that such a value exists means that when you take a loss in your portfolio of a fixed dollar amount, then the value of taking that loss is a lot greater than it would seem on the surface because it boosts your survival quotient.
Here are two examples:
A. Trader John runs a portfolio of $50,000. He is a reasonably skilled trader who understand the basics of risk control and invests semi-aggressively. He can reasonably be expected to bring in 10% per annum when all of the volatility is averaged out over the long-term. The $50,000 compounded on an annual basis at 10% over 20 years will become roughly $340,000 at the end of the period. If Trader John was unable to control his risk, then not only would he lose a percentage of his current capital, he would also jeopardize the possibility of him getting to the $340,000 that could be his at the end of his 20 year trading period if he sticks to simple risk management rules.
This simply means that Trader John cutting losses and having a defined risk management strategy raises his survival quotient. Each loss actually benefits his portfolio that much more because it allows him the possibility to boost his survival quotient, raising the chances of him surviving to continue speculation in the markets and achieve his expected return.
B. Trader Max runs a portfolio of $1,000,000. He is very aggressive and allows his losses to run considerably. A fatal event is not a matter of if but rather when with Trader Max. He is a talented trader who has not put together a defined risk control methodology. His survival quotient is very low. If he was to put together a controlled plan of attack for cushioning risk, he could expect to see average gains of 14% per annum when all the volatility is averaged out of the long-term. This means on a compounded basis his $1,000,000 would become $14,000,000 at the end of a 20 year period.
The reality of the situation is that Trader Max loves leverage, loves homeruns and loves going for it on every trade. He has been averaging gains of 35% over the past few years. However, he has had several close calls that he was able to reverse through aggressive trading methods. The fact that the risk of ruin is so great for Trader Max (a low survival quotient) means that whenever he takes a loss it is actually a greater loss than what it looks like on the surface.
Not only is he losing 4%, as an example, on a single trade. But since his survival quotient is low then he is losing a portion of the $13,000,000 he can be expected to make if he had proper risk control measures in place. Therefore, his loss on trades is actually much greater than it seems because his survival quotient is so low.
On the surface, it seems that Trader Max has greater potential because his gains are greater. However, when you look beneath surface, it becomes apparent that Trader John has far greater potential because his survival quotient is high enough to virtually guarantee that he survives to collect over the long-term. The losses he takes are actually a lot less than what they appear to be because in the act of taking the loss he is raising his survival quotient and effectively, securing a piece of his future monetary gains.
Conversely, Trader Max is seemingly controlling his losses to a certain extent. However, his losses are actually quite a bit more than it would seem on the surface, as the amount of potential future gains he is leaving on the table every time his survival quotient drops further is not being accurately factored into the loss at that time. A loss of 4% on a single trade is actually significantly more since it can be expected that his survival quotient will eventually drop to zero.
This is an important concept to understand. Next time you take a loss, realize that the loss you are taking and your discipline in taking that loss actually raises your survival quotient further raising the possibility that you will make it to your 10, 20 and 30 years goals in the financial markets. Furthermore, you can also take comfort in the fact that the loss is significantly less than it would seem since your future gains are insured by you being disciplined enough to take a loss today.
