Size Matters

One of the more interesting speeches that I remember from Stocktoberfest 2014 was given by Jack Schwager – the author of the well-known Market Wizards Books. He told the story of Martin Schwartz and how he managed to achieve 25% monthly returns for a prolonged period of time. This is 25% per month, not per year. Schwartz’s trick? He would start with $400k and every time his account goes to 1mill, he would take some money out of the market and start over again with 400k. For his type of trading, he had to work with a smaller amount. I see the same behavior in many intra-day traders – they work with relatively small amount of capital and constantly take money out of the market. This behavior might seem counter-intuitive to many as it fails to take advantage of money compounding, but in fact it simply recognizes the limits of every trading approach. The truth is that capital size is like gravity – it matters, a lot.

Everyone desires to manage more money, but not everyone realizes that more capital could actually mean fewer trading opportunities. I wrote about this earlier this year and it remains relevant. There is a reason why a small 10-million dollar hedge fund could easily outperform a 10-billion dollar hedge fund. A small fund or a trader could afford to have 5% capital allocation and take hundreds of short-term trades in a year. A larger fund has a lot less great liquid opportunities in a given year. The only way for a 10-billion dollar fund to achieve good return is through concentration – putting 20% or more of capital into one great setup. The latter just follows a very simple rule – concentration creates wealth, diversification protects it.

Have you thought on the subject of capital size? At what point your capital size will negatively affect your performance?

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