Arriving at an Optimum Suggested Account Size for Your Portfolio
To arrive at what we will refer to as the "optimum" account size for a given portfolio, simply add together the "conservative" account size and the "aggressive" account size and divide by two. This is the amount of capital you should ideally consider having in your account before trading that particular portfolio. For the example that we have been using, the aggressive account size is $20,805 and the conservative account size is $45,000. To arrive at the "optimum" account size for this portfolio we simply add these two values together and divide by two. By adding $20,805 to $45,000 and dividing by two we arrive at an "optimum" account size of $32,903.
Digging a Little Deeper
Assuming you have all the required data there is some useful information you can glean by analyzing monthly returns. Ideally you will have at least 30 months of real-time and/or hypothetical monthly data to examine. Using the formulas below can help you to estimate what you can realistically expect from your portfolio in terms of risk and reward.
- Expected Annual % Return = Average monthly % return compounded over 12 months. For our example portfolio, the average monthly return is $729 or 2.2% of $32,903. By compounding this monthly return over 12 months we can estimate an average annual return of 30.8%.
- Expected maximum drawdown in $ = Standard Deviation of monthly returns x 4. The standard deviation in monthly return for our example port folio is $1,500, so we should be prepared to sit through a maximum drawdown of $6,000. In other words, any drawdown we experience which is less than $6,000 must be considered "normal" for our account using our chosen approach.
- Expected maximum drawdown in % (Expected maximum drawdown in $ / Account Equity) -$6,000 / $32,903 = 18.2%.
- P/L / Standard Deviation Ratio = Average monthly % return / standard deviation of monthly returns. For our example portfolio P/L = $729 and Standard Deviation = $1,500, so this ratio is 0.49. Anything above 0.5 is outstanding.
- Expected Profit / Drawdown Ratio = (A / C) - What you are looking for is enough upside to justify the expected volatility. The minimum ratio to consider would be 1-to-1. For our example portfolio A= 30.8 and С = 18.2, so E = (30.8/18.2) or 1.69. Anything above 1.5 is outstanding.
- % of Profitable 3-Month Periods - For our example portfolio, 79.8% of all 3-month periods have been profitable.
- % of Profitable 12-Month Periods - For our example portfolio, 98.3% of all 3-month periods have been profitable.
A high percentage of profitable 3-month and 12-month periods is a major plus from a psychological standpoint. A trader is far more likely to continue trading using a given approach if he experiences a high percentage of profitable 3- and 12-month periods.
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