Arriving at a Conservative Suggested Account Size
If you are able to calculate or at least estimate monthly returns from your portfolio it is possible to arrive at what can be referred to as a "conservative" account size. In calculating a "conservative" account size for the portfolio in the previous example, please note that neither the portfolio nor the dollar amount of profit or loss changes. What changes is the amount of capital committed to trading that portfolio, the percentage rate of return and the drawdown as a percentage of account equity. By using more capital we can effectively reduce the magnitude of any drawdowns on a percentage basis to a tolerable level.
To use this method it is advisable to have at least 30 month's of data. When performing mathematical analysis at least 30 elements are required in order to generate statistically meaningful results. To use this method:
- First add up all of the monthly profit/loss figures and divide by the number of months considered in order to calculate the average monthly dollar profit for the portfolio as a whole.
- Calculate the standard deviation of monthly returns (See this page for the mathematical formula for calculating standard deviation).
- Multiply the standard deviation of monthly returns by 3 and then divide the result by 0.1.
For a given set of data, a one standard deviation move above and below the average encompasses 2/rds of the data under consideration. A two standard deviation move above and below the average includes 96% of the data and a three standard deviation move above and below the average includes 99% of the data. By multiplying the standard deviation of monthly returns by three we arrive at a dollar figure that encompasses 99% of all previous monthly gains or losses. By dividing this value by .1, we are attempting to insure that there is a 99% chance that you will not experience a monthly loss in excess of 10%. This assumes of course that future results will be similar to past results.
Let's say that the standard deviation of monthly returns for our earlier example portfolio is $1,500. We multiply this value by three to arrive at $4,500 and then divide this value by 0.1 to arrive at a suggested "conservative" account size of $45,000. If future results are similar to past results, then by trading this account with $45,000 there is a 99% probability that we will not experience a monthly drawdown in excess of 10% (or $4,500 in this case).
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