t do some work up front in fitting your program to the financialresources available to you.
Finally, you need to give some thought to the infrastructure aspects ofyour portfolio management activities. In order to do so, you should havesome idea about everything from the way that prices change over time (dothey  move  on  a  minute-by-minute  basis,  like  technology  stocks,  or  withless  frequency,  such  as  private  equity  investments?),  what  is  required  tocalculate  your  portfolio  performance  on  a  real-time  basis,  and  what  youwill need to ensure that you have the information and other resources nec-essary to adjust your position in a timely and efficient manner when themarkets move. In addition, you must make sure that you have an efficientnetwork of brokers and/or counterparties who can assist you in the exe-cutions of transactions when adjustment becomes necessary. 
Just as you shouldn’t trade at financial levels beyond your means, youprobably don’t want to be trading European equities or Japanese govern-ment bonds unless you are prepared to monitor your positions during theoff-cycle hours in which they trade. It’s also probably a good idea to makesure, if you are trading these markets, that there are brokers at your dis-posal who are both at their desks and awake enough to be useful shouldtheir phone ring and it happens to be you. Again, these points may seemlike nothing more than basic common sense, but I am constantly amazedat  the  multitude  of  otherwise  rational  and  intelligent  individuals  Iencounter who are happy to dive into markets that are quite unfamiliar tothem and that experience the lion’s share of price movement when theseindividuals are either asleep or otherwise engaged. I even know a few peo-ple who are successful at this; but for the vast majority of people, this is apath they will want to avoid.
Hopefully,  by  now,  we  are  in  agreement  that  your  trading  programshould be one that is consistent with your financial resources and objec-tives, that causes you to operate in markets that you understand and feelyou can exploit, and that features the appropriate tools to enable you toefficiently manage your portfolio as market conditions change. 
Now  comes  the  tough  part:  sticking  to  your  program.  There  are  notricks here. Concentrate your trading exclusively on the group of finan-cial  instruments  on  which  you  have  committed  to  focus,  utilizing  themethodology you have chosen to capitalize on the market inefficienciesthat  you  set  out  to  exploit,  under  the  portfolio  management  plan  youhave  created.  The  more  rigorous  you  are  in  these  terms,  the  better  offyou  will  be,  particularly  at  the  outset  of  your  endeavors.  If  you  havedecided to trade in specific dollar or share-size increments, stick to thesecommitments. If you have promised yourself that you will liquidate anyposition that moves against you by 10%, don’t renege on this promise. Ifyou are willing to buy securities only under certain specified conditions
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(e.g., the 200-day moving average has crossed the 30-day moving averageon  the  upside,  or  the  company  reports  three  consecutive  quarters  ofimproved  earnings),  then  don’t  put  on  trades  unless  these  criteria  aremet. Use statistics to monitor your success in these areas and then fine-tune your strategies accordingly. The alternative is a breakdown of disci-pline that places you entirely at the mercy of the markets and that willnegate any chance you might otherwise have had to become the masterof your trading destiny.
IF THE PLAN’S NOT WORKING, CHANGE THE PLAN
I love contradicting myself like this; it’s such good fun. What I mean to sayhere is that you should not feel compelled to adhere to a single methodol-ogy for all time, irrespective of market conditions, its level of success, andother factors. Quite the contrary, it is essential for you to adapt your strate-gies as markets evolve and as your own individual circumstances change.Change is both useful and necessary, but it should be the end result of care-ful planning and undertaken in an organized fashion that will help maxi-mize  the  prospects  for  success.  Specifically,  you  should  only  considermodifying your strategy when and if you can generate convincing answersto the following six questions:
1. What am I trying to accomplish?
2. What strategy most effectively achieves these objectives?
3. How can I efficiently adopt my modes of operation to my new
strategy?
4. How will I measure success or failure?
5. What am I willing to risk to determine if my new course of action is
the correct one?
6. What parameters do I need to impose on myself to ensure that I willnot lose more than this amount over the course of the experiment?
In an ideal world (I’ve never been there, but they tell me it’s nice), it isbetter to undertake the risk and the effort of modifying strategies at pointswhere you are making money trading so that the project benefits from theconfidence  and  the  availability  of  resources  that  will  contribute  to  itsprospects for success. I encourage consistently profitable traders and port-folio managers to periodically set aside small portions of their capital forexperimentation with new strategies. The most successful market partici-pants whom I have encountered have always been proactive in modifyingand testing new strategies when they are doing well. 
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However, there will come a time in many trading careers when a mod-ification  of  strategy  is  mandated  by  poor  performance,  and,  as  such,  thechanges  must  be  undertaken  under  conditions  of  weakness  rather  thanstrength. In these latter cases, the preparatory efforts captured in the sixquestions are of the utmost importance. When what you have done in thepast is no longer working and you need to change your approach or quit,the worst thing you can do is to carry out changes in a random, idiosyn-cratic manner. You must have some idea of what you hope to gain by thechange, and you must create a risk control plan that will preserve portionsof your capital that may be required to pay your bills (for personal accounttraders) or allow you to retain your job (for professional traders). Takingthese steps can mean the difference between sustained success and cata-strophic failure.
SEEK TO TRADE WITH AN “EDGE”
A couple of decades ago while suffering through the indignities of the MBAprogram at the University of Chicago, I was exposed to a theory known asthe Efficient Markets Hypothesis, which, because I believed it (and have,truth be told, been unable to shake this belief in the many years that havesince  passed),  ruined  any  thoughts  I  might  otherwise  have  had  aboutembarking on a career in portfolio management. This elegant little theorysuggests that all financial instruments are at all times priced on the basisof  the  decision  making  of  rational  individuals,  who  are  equipped  with  acomplete and accurate set of fundamental information. 
While many would quibble with the veracity of this notion (I’ve readfour  books  this  year  that  declare  the  Efficient  Markets  Hypothesis  to  beutter rubbish), there are dramatic implications for those who buy into it:The  current  price  of  any  instrument  you  might  want  to  trade  is  the  eco-nomically accurate one, and it is unrealistic to expect your investments tomove favorably on anything other than a random basis.
Depressing concept? Well, yes and no. It certainly is if you buy into it fullstop. However, like so many other notions that find their origins in the ivorytowers  of  academia,  what  is  true  in  theory  falls  a  bit  short  in  practice.Although you can certainly count me among those who believe that marketstend to price themselves efficiently at equilibrium, there are all sorts of nitsin the real world that create inefficiencies that can be exploited in a systemicfashion. As we mentioned early, the market term for exploiting a recurringinefficiency is known as trading with an edge. Though I blaspheme by doingso, I submit that there are edges all around us and that your primary strate-gic mission as a trader should be to seek them out. If you can consistently
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find and exploit edges, there is no limit to the amounts of money you canmake; if you trade without an edge, it essentially means that you are tradingefficiently priced assets and can only hope to profit by virtue of the fact thatnew  information  coming  into  the  marketplace  is  favorable  to  your  posi-tion—a 50/50 proposition at best and not one that lends itself to the riskingof either hard-won or even hard-inherited assets.
Structural Inefficiencies
The  types  of  edges  that  exist  in  the  markets  fall  broadly  into  two  cate-gories: (1) structural inefficiencies that bestow advantages on certain par-ticipants  and  (2)  methodological  approaches  that  are  better  adapted  tomarket dynamics than the norm. Let’s first take a look at several types ofstructural inefficiencies.
Timing  of  Information-Based  Decision  Making.It  is  the  legalobligation of all those with information that is likely to impact the price ofmost financial assets to disseminate this information in a way that allowsthe entire market to receive it and process it in a contemporaneous fash-ion. Similarly, it is illegal to trade on information not otherwise disclosedto the public at large. These mechanisms on the whole work pretty well.There are few investors or investment groups that I am aware of who tradedirectly on the basis of insider information. Those that do so risk prosecu-tion at every minute, and for the rest of their lives. If you doubt this, feelfree to consult either Martha Stewart or her pal Sam Waksal. 
That being said, there are numerous, information-based edges availablein the markets. Perhaps the most prevalent of these fall into the category ofdisparities in terms of the time that it takes investors to process importantpieces of data. This, in turn, is due to the following practical realities:
• Although information has to be disseminated to the entire market at
once, investors receive this information at different times.
• Different  investors  analyze this  information  over  varying  time
horizons.
If these things are true, it follows that, contrary to what I was taught,it is possible to gain an advantage over other investors in terms of both theprecise time at which you receive pertinent information and the speed withwhich you process it. In both instances, the professional trader has a bigadvantage over the rest of us; and in general, the success of any investmentprogram is going to be positively correlated with the amount of time youare  willing  to  devote  to  both  scanning  the  markets  for  important  data
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points and analyzing these data points as they become available. Profes-sionals get paid to spend their time in this fashion; hence, the advantage.A word to the wise: Don’t cling too tightly to any illusions that this infor-mation-processing disparity doesn’t exist or isn’t important. There are mar-ket  participants  who  are  relentless  in  this  process;  and,  very  clearly,  theyhave an edge over their peers. The question you should ask yourself is: Areyou a potential beneficiary or a victim of this disparity? If you’re workingconstantly at these processes, combing the full universe of available infor-mation  sources  and  then  pouncing  on  the  data  points  you  gather  with  adetermined abandon, it is likely that with a modicum of intelligence, you cangenerate and sustain an information-processing edge. However, if you haveneither the time nor perhaps the inclination to attack these challenges withall of the energy you can bring to bear, I would say that by definition you areoperating at a disadvantage to those who have made this commitment.
Transaction  Flow/Market  Proximity. As  we  discussed,  the  moreactive you are in the markets, the better you are likely to perform. In addi-tion  to  the  risk  management  benefits  that  active  trading  brings,  you  willfind yourself much closer to the ebbs and flows of the marketplace, andthis carries enormous potential benefits. In the first place, you start to seewhat the actual trading action is all about in your securities, on a minute-by-minute basis. Further, if you’re active enough (and operate with suffi-cient capital), your market status may evolve beyond that of a mere par-ticipant into that of a liquidity provider—a designation assigned only tothose who can be relied on to participate in transactions flow at materialtrading sizes on a sustained basis. 
Those who have achieved this level of critical transactions mass arecommonly referred to as market makers, and their presence is essential tothe efficient functioning of the markets as a whole. Moreover, market mak-ers are routinely rewarded for their willingness to take part in the transac-tions flow, with the rewards taking the form of being able to buy on the bidand  sell  on  the  offer  (thereby  extracting  the  “bid/offer  spread”).  In  addi-tion, market makers often have an opportunity to develop a deep under-standing of how the securities on which they are focused trade, includingsuch details as who the routine buyers and sellers are, what type of priceaction they respond to, and how they process fundamental information.
Market  makers  typically  operate  most  efficiently  when  they  concen-trate exclusively on a relatively small number of tradable instruments thatthey make it their business to understand in extensive detail. For those whocan  manage  this  process  with  any  degree  of  efficiency,  the  methodologyoffers a formidable edge, which should deepen over time as the individualsinvolved  gain  greater  understandings  of  the  nuances  of  the  markets  inwhich  they  trade.  After  many  cycles  of  economic/financial  data  releases,
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certain patterns start to emerge, often providing road maps for capitalizingon exploitable inefficiencies. 
One of the most efficient of these methodologies seeks to reverse engi-neer the flow of funds in and out of financial instruments generated by largeinstitutions. I’ve worked for a couple of places that used this methodology,and,  boy,  did  they  have  edges.  Because  the  big  institutions  often  deal  inposition sizes that are large multiples of the daily volume of a given secu-rity, it can take days and sometimes even weeks for them to establish/liqui-date a position and to rebalance their portfolios. The market makers in thesecurities in question know these patterns, having a pretty accurate pictureof  which  large  participants  are  holding  which  securities  (in  the  case  ofmutual funds, the government is kind enough not only to force them to dis-close their positions on a routine, periodic basis, but also to establish min-imum  holding  periods  for  securities  in  the  portfolio),  the  price  levels  atwhich they have executed, and often (at least through inference) even theprice  levels  at  which  they  are  likely  to  adjust  their  exposures.  When  thetime comes for these institutions to rebalance, market makers may have theopportunity to extract large spreads from the market—either by taking theother side of these trades or by riding along with them and benefiting fromthe price action that their trading activity creates. 
For example, a given large mutual fund may find itself wanting to liq-uidate a 5-million-share holding of a given midcap stock; but due to liquid-ity constraints, it can only do so over a period extending more than a weekand in increments of 100,000 or 200,000 shares at a time. As these tradeshit the tape, market makers may quickly surmise who the seller is, come toa very informed hypothesis that all 5 million shares are for sale, and usethis knowledge to their own trading advantage. 
Of course, it takes a significant commitment combined with the appro-priate market proximity to operate as an effective market maker in a givenfinancial instrument. Professionals who sit on trading desks of major bro-kerage houses enjoy this edge, as do floor-based market participants, alongwith a handful of private investors. Much of the price action in the market issimply  the  end  result  of  transactions  between  large  investors  and  marketmakers.  Only  a  few  well-placed  souls  have  an  edge  in  this  process,  but  itimpacts us all. I think the market is much better off for the presence of mar-ket makers, and one thing’s for sure: The good ones are well-paid for theirefforts.
Being  “the  House.” One  very  important  group  of  market  makerstypically carries an edge into every transaction—those who operate as thedesignated liquidity provider for all transactions processed through a givenmarket mechanism. Those with this designation include floor brokers onregulated  exchanges,  those  who  sit  at  banks  and  broker  dealerships
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trading against clients seeking access to specific markets, designated liq-uidity providers on electronic exchanges, and a small number of others. Inexchange for a willingness to act as a buyer for investors wishing to selland as a seller to investors wishing to buy, these entities typically are ableto  buy  at  the  bid  and/or  sell  at  the  offer,  thereby  creating  a  sustainablerevenue flow that can be very lucrative indeed. 
Of  course,  the  responsibilities  that  house  traders  assume  are  almostnever  riskless,  as  they  are  routinely  subject  to  a  nasty  type  of  exposurecalled event  risk,  under which they might theoretically be caught with alarge position in a market that has just received dramatic new informationthat is negative to their position. In order to incentivize market makers toassume event risk, the bid/offer spread has to be sufficiently large so as tocompensate  them  handsomely  under  the  vast  majority  of  market  condi-tions. Here’s a little news flash: It usually is.
There are a number of other exploitable inefficiencies of this nature, butthese examples should give you the general idea. The common thread acrossthem is that they may be available only to certain types of market partici-pants  (mostly  professionals)  and  cannot  be  manufactured  unilaterally  byindividuals not operating in the specific structures that are the beneficiaries.
Methodological Inefficiencies
There are also certain methodological edges that just about anybody cancreate through enlightened portfolio management.
Trading  Efficiency  and  Risk  Control. As  indicated  throughoutthis book,  I  believe  that  there  is  a  very  specific  science  that  underliesthe business  of  trading  and  investing.  In  previous  chapters,  we  havedescribed it as being contained in some combination of being right morethan you are wrong and/or making more when your positions work in yourfavor  than  you  give  back  when  they  are  against  you.  While  you  may  notalways see the market clearly enough to be successful on the basis of posi-tion selection alone, I have argued that it is in your power to control theratio of what you make on winners to what you remit on losing trades—and this, as I have repeatedly stated, lies at the very core of the science oftrading as I find it.
We have gone into great detail in previous chapters about what it takesto maximize the ratio of gains on winners to losses on losers and so willnot do more than repeat at the highest conceptual level what we believe tobe the critical subtasks:
• Select positions where the gains you realistically expect significantly
exceed the losses you are willing to take.
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• Rigidly adhere to your objective/loss targets.• Determine the amount of capital you invest in any one transaction on
the basis of its risk/reward characteristics.
• Seek  at  all  times  to  minimize  your  transactions  costs,  particularly  in
terms of the prices at which you are trading.
This  seemingly  simple  and  entirely  achievable  set  of  protocols  is  anedge in itself, and a significant one at that. What is even better, it is avail-able to all market participants. If you are able to master these objectives,you  can  avoid  the  disasters  that  make  trading  and  investing  such  a  frus-trating experience for so many. You will also enhance returns during thoserare but exquisite moments when the sea appears calm and there isn’t acloud on your portfolio horizon.
Superior  Portfolio  Construction/Position  Selection.It  is  alsopossible to derive an edge by being better at analysis than other marketparticipants.  In  theory,  these  types  of  edges  can  take  many  forms,  themost obvious of which are driven by individuals who try to dig deeper andprocess fundamental information with a keener eye toward future pricemovement than the rest of us. Most professional money managers, includ-ing  those  who  manage  the  mutual  fund  assets  in  which  so  much  of  thewealth of individual investors is entrusted, strive to fall into this group. Ina  more  extreme  example,  hedge  fund  managers,  whose  services  areunavailable to a large majority of investors and who typically charge feesthat are many multiples of those paid to mutual funds, must have a supe-rior selection methodology in order to justify their very existence. Beyondthis, there are quantitative strategies that seek to benefit from such con-cepts as a superior ability to price options and other derivatives, as wellas  the  ability  to  identify  and  benefit  from  small,  nonintuitive  discrepan-cies in the prices of similar instruments (so-called relative value trading),all  of  which  can  be  categorized  as  attempts  to  create  superior  portfolioconstruction models.
The bona fide existence of these “better mousetraps” is a matter thatis very difficult to dispute. Be that as it may, you need to be careful aboutaggressively deploying capital in a trading strategy that you feel has a port-folio  construction  edge.  In  the  first  place,  don’t  underestimate  the  chal-lenges here; and above all, don’t let your emotions call the shots here, asthis flies in the face of those elements of the efficient markets hypothesisthat are most appealing: (1) Everyone is ultimately dealing with the sameset  of  information,  and  (2)  prices  are  determined  by  investment  agentsmaking rational decisions. If you really have something special, test it outon small capital and scale with your profits. Trust me on this one; you’llfeel better about yourself in the morning.
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Finally, even if you do find a methodology that anticipates price move-ment with greater accuracy and consistency than others in the market, myexperience is that sustaining such an edge into perpetuity is nearly impossi-ble. As the saying goes, there’s nothing new under the sun, and this includesmethods for figuring out the future relative worth of economic assets. Oth-ers are at least nominally aware of what you are doing; and if it works, theywill most certainly try to begin doing it themselves. The more piggybackersthere are, the smaller the profit margins that will accrue to your methodol-ogy, and the greater the risk you have to take to capture them. 
Thus, in order to continue to beat the market by the sheer forces of yourinsight and intellect, it is necessary not only to spot anomalies that virtuallyno one else is seeing, but also to successfully sustain this process of discov-ery and adaptation when the market inevitably figures out what you’re doingand removes the conditions that you have heretofore been able to exploit.
There  is  one  very  important  exception  to  the  dismal  dynamics  justdescribed: a methodology known as hard work. Most markets lend them-selves to fundamental analysis, and it is possible to be more thorough andto capture a more complete picture of the economics of the instrumentsyou are trading than at least a subset of other market participants. If there’sa God in heaven, one ought to have a sporting chance at profitably exploit-ing the associated information advantages. For example, in the equity mar-kets, you can gather a virtually unlimited amount of written information onan individual company, derived from such sources as the documentationprovided  by  that  company  (financial  statements,  press  releases,  proxystatements,  etc.)  and  analysis  made  available  by  brokerage  houses  andresearch firms. In addition, with a little bit of ingenuity, even amateurs cangain  access  to  critical  information  sources  within  and  around  the  com-pany, including investor relations personnel and agents of customers andsuppliers  for  the  firm.  Finally,  the  ability  to  exchange  ideas  with  otherinvestors  (particularly  in  the  Internet  age)  is  constrained  only  by  theamount  of  time  you  are  willing  and  able  to  devote  to  this  effort.  Yourreturns should be positively correlated to both the effort and the qualitythat  you  bring  to  the  research  elements  of  your  trading  program.  In  myexperience, the very best traders in the world are the ones that work thehardest. It’s as simple as that.
The  universe  of  sustainable  edges  extends  well  beyond  those  I’ve  cov-ered, and I am not suggesting that you need to map your portfolio man-agement strategies into one of these templates. What I am saying is thatyou should absolutely frame your trading program around a specific, real-istic edge, and understand the consequences of being active in a marketthat is full of participants who are systematically exploiting inefficiencies,while you are not.
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PLAY YOUR P/L
As we have discussed in great detail, among the most crucial determina-tions  you  will  need  to  make,  over  and  over  again,  is  how  much  risk  youshould take in your portfolio at any given time. I have tried to reinforce thenotion that these decisions should be based on an analysis that takes intoaccount both internal factors, such as the amount of risk capital you haveat your disposal, and external considerations, including the quality of themarket  opportunities  that  you  believe  are  available  to  you  at  any  giventime. I am fond of portraying the risk-taking decision set through the fol-lowing two-by-two Harvard Matrix: 
RiskCapital
High
Low
Opportunity Set
Low
High
Do what you want, but there’s no reason to be ahero here.
Good time for a vacation.Have you thought aboutvisiting Grandma lately?She’s not getting anyyounger, you know.
Go get ’em, Tiger!!!!
Here’s where we separatethe wheat from the chaff.My advice is to use extremediscretion here, as this boxhas destroyed manytrading careers.
This matrix pretty well sums up most of the capital allocation decisionmaking  you’ll  ever  have  to  undertake;  and  clearly  the  difficult  choicesreside in the northwest (High-Low) and southeast (Low-High) quadrants.Life, by contrast, is relatively simple up in Bangor and down in San Diego,but we risk managers actually prefer Seattle and Miami, as they are muchmore job-secure climates for those of our ilk. 
I have argued that no matter what types of opportunities you believeare out there, you should at no point be invested at levels beyond whichthe associated losses place you in conditions of either financial or profes-sional  duress.  The  volatility  analysis  and  risk  prediction  tools  I  havedescribed  in  various  chapters  of  this  book  are  designed  to  provide  youwith the opportunity to size your exposures within parameters of accept-ability.
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Underlying the principal of loss reduction is the undeniable reality thateven for guys like Bill Gates, the ability to sustain losses is finite. There-fore, by definition, an investor’s ability to take risk increases with profitsand decreases with losses. I cannot overemphasize the importance of plac-ing  your  recent  performance  as  the  primary  consideration  in  your  risk-assumption decision-making process. Moreover, in operating under theseconstraints, the following core principals should guide you:
• Your risk profile should never allow you to lose more than the amountyou have specified as your risk capital except under the most extraor-dinary and unforeseeable of market events (e.g., a stock market crash).• As markets move against you and you draw