The Importance of "Capital Management"—Differences between "Managing 1,000,000 yen for 5 stocks" and "Managing 10,000,000 yen for 50 stocks" — Japan Stock System Trade Basic Course ⑥

The Importance of Money Management ~ The difference between "Having 1 million yen for operating funds with 5 stocks" and "Having 10 million yen for operating funds with 50 stocks"

I am Takeshi Nishimura, a securities analyst and a seminar lecturer on system trading at Fairtrade Co., Ltd. In this course, we will explain in simple terms and with plain expressions so that everyone watching can understand "system trading" from the basics. Please stay with us until the end. The theme this time is the importance of money management ~ the difference between "1 million yen for operating funds with 5 stocks" and "10 million yen for operating funds with 50 stocks." Now, let's get into the content.

In several previous sessions with different themes, we conducted backtests using breakout strategies as samples. After viewing them, what impressions did you have? Even in investment methods that are widely accepted, whether backtesting has been conducted or not can make a totally different sense of security when you actually invest your own funds.

For example, when you actually test over decades of data the methods of so-called charismatic traders, you often find that “they are not as usable as you thought.” As system trading becomes more widespread, such ambiguous investment information is weeded out, which I think is a positive for many investors (traders). Now, let's get to the main topic.

The theme is the importance of "Money Management (risk/control)."

The meaning of "money management" varies in many ways. It is difficult to explain everything in one go, so this time we will focus the内容. We will concentrate on "how the diversification of assets (capital) affects performance" and proceed with the explanation. Please review the breakout buying/selling rules and verification results that have appeared several times before. (The buy/sell rules are the same as before, but the test period is different, so the verification results differ slightly.)

┌───────────────────────────────┐
[Buy Rule] Update the high price of the past 250 days (the highest closing price)
[Sell Rule] Update the low price of the past 125 days (the lowest closing price)
※ Trades are executed at the next day's opening price └───────────────────────────────┘

┌───────────────────────────────┐
[Verification Result] (Test period: 2000/01/01 – 2008/06/30)
Win rate: 41.2%
Average profit/loss: +11.13%
Average holding period: 324.8 days
└───────────────────────────────┘

From the above verification results, with an average profit of about +11% it can be said that the trading rule is effective in the long term. However, there is a fatal drawback in these results. The verification assumes that every trade was executed strictly according to the rule. In real trading, except for extremely wealthy individuals, it is impossible to trade every stock that meets the rule.

For example, if 100 stocks meet the buying rule, purchasing all of them would require tens of millions of yen in funds. Therefore, to perform a more realistic verification, backtesting must take into account the amount of operating funds you actually have.

So, this time we will show backtest results for two actual fund amounts. The two verification results below are exactly the same 250-day breakout method as just now.

What differs is that the test is conducted assuming different amounts of operating funds.

■ Verification results when operating funds are 1 million yen and diversified into 5 stocks

■ Verification results when operating funds are 10 million yen and diversified into 50 stocks

A brief supplement. When allocating 1 million yen across 5 stocks, even if there are 10 candidates meeting the buying rule, you can only buy up to 5 of them (of course, if you have funds after selling, you can buy more). Also, when actually buying, you need to determine priority for purchases, but for this time we will use "buying orders by highest liquidity (highest trading volume) of the day."

■ Verification results for 1 million yen diversified into 5 stocks
(Test period: 2000/01/01 – 2008/06/30)

┌───────────────────────────────┐
Win rate: 41.3%
Average profit/loss: +6.55%
Average holding period: 177.85 days
└───────────────────────────────┘

■ Verification results when 10 million yen is diversified into 50 stocks
(Test period: 2000/01/01 – 2008/06/30) ┌───────────────────────────────┐
Win rate: 41.3%
Average profit/loss: +7.67%
Average holding period: 172.55 days
└───────────────────────────────┘

So, how about it? The breakout method had an average profit of about +11%, but when you add a constraint on the amount of funds, the results change significantly, as you can see.

Essentially, the fewer stocks you diversify among, the larger the fluctuation in performance; the more you diversify across many stocks, the more the results for all stocks traded tend to converge toward the average. Thus, even when using the exact same investment method, the way you diversify and trade can cause substantial differences in performance.

Even with similar buying/selling rules, individual trading performance can vary greatly due to differences in money management, including how you diversify your funds. In fact, to profit in trading, you do not need the strongest investment method; it is enough to have a reasonably effective trading rule and proper money management.