the hopes of minimizing the time period ofunderperformance. Your instincts will tell you to load up and make it allback as quickly as possible—and your instincts couldn’t be more wrong.For  enlightened  portfolio  managers  who  wish  to  have  long  careers,  theprice of a P/L setback is measured not in the dollars needed to recover butin the time necessary to make those dollars. 
By contrast, those who choose to increase their exposures after a dif-ficult  interval  may  see  this  strategy  pay  off  once,  twice,  or  even  severaltimes; but ultimately, it is a ticket to disaster where they will bomb out—perhaps in spectacular fashion. A mentor of mine, and one of the true pio-neers of modern-day portfolio management (okay, it’s Paul Tudor Jones),is fond of saying that sooner or later, we all go to the trader graveyard. Inmy experience, this does not actually have to be the case. I believe that ifyou cut losses during periods of performance difficulty, you can, in fact,trade into a state of immortality.
In addition to arguing the merits of setting your exposures as a posi-tive function of performance, I will discuss simple statistical tools that willenable you to operate at exposure levels that will help you to stay in the
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game  indefinitely,  no  matter  how  badly  you  may  suck  at  reading  themarkets.
HEY, JOE, WHERE ARE YOU GOING WITH THE RISKIN YOUR BOOK? 
Listen, Joe, I need to speak to you about your portfolio. I’ve been watching youclosely  over  the  past  few  weeks  (of  course,  as  your  risk  manager,  this  is  myjob). I know your performance has been a bit disappointing, but I want you toknow I’m not particularly troubled about that. You’ve been through this before,and I’m confident that you’ll pull through quite nicely, as you always have inthe past. However, I do sense a certain anxiety on your part; and I won’t lie toyou,  this  concerns  me  a  great  deal.  I  know  it’s  getting  later  in  the  year,  andyou’re anxious to reverse your performance so you can get paid. I also sense,and correct me if I’m wrong here, that you’re sniffing big opportunities in yourspace.  Bottom  line:  My  instincts  tell  me  that  you’re  debating  whether  nowwouldn’t be a perfect time to increase your risk profile. 
What’s that? Did I hear you say you want to take a shot here? Of course,you do! After all, we’re looking at a world-class market opportunity, are wenot? You’ve done your homework, and you couldn’t possibly be wrong, couldyou? Besides, you’re tired of losing money, and I don’t blame you one bit forthis.  To  put  it  bluntly,  your  recent  performance  has  sucked,  and  the  onlyrational  answer  is  to  trade  bigger.  There’s  certainly  no  portfolio  manage-ment problem I’ve ever encountered that couldn’t be solved by simply trad-ing in bigger sizes, and God Almighty didn’t breathe life into us just to tradefor  chump  change.  Once  you’ve  nailed  your  big  trade,  a  lot  of  things  aregoing to change for the better. You’ll be nicely profitable, and you’ll be in agreat position to move forward in the markets in a very disciplined manner.All you really need to do is to get this next one right, and everything else willfall into place.
But what if you’re not right? Trust me here, you’ll have bigger problemsthan you are anticipating at the moment—so big, in fact, that I strongly sus-pect  the  upside  is  not  worth  the  downside.  For  one  thing,  you’ll  have  lost  agood deal of money—in the process further exhausting your risk capital at amost inopportune time. What’s more, it will be difficult, without great effort, torationalize  away  the  following  unpleasant  realities:  (1)  Your  thoughts  aboutwhat constitutes a high-conviction trading opportunity are somewhat less thaninfallible; and (2) you’ve failed pretty unambiguously at the challenge of capitalpreservation —at a point when capital preservation was a particularly importantobjective. At that point, your capital reserve and confidence will be at an ebb;and what might be worse, I will be looking more fervently over your shoulderthan ever before.
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You now have the opportunity to play your big idea in smaller size. If you dothis, no matter what happens, you will experience a palatable range of outcomes.Assuming you nail the trade, you should still make money (just not as much asif you had played it in large size). If the markets go against you, the financial dam-age will be minimal. Either way, you will gain the confidence that emanates froma sound and consistently applied risk management program. All of this could beyours by simply setting aside some of your remaining capital for a rainy day (sortof like an investment, if you catch the drift) and sacrificing some potential upsideon a single set of high-conviction market ideas. At the end of the day, you’ll prob-ably  end  up  ignoring  my  advice  and,  if  things  go  wrong,  just  blaming  the  riskmanager. Why not? Everyone else does. But for your own welfare, I urge you totake a good look in the mirror and ask yourself whether you might’ve had justthe teeniest hand in creating your own misery from this sorry episode.
Always  Save  a  Healthy  Amount  of  Risk  Capital  for  “SpecialSituations.” Although  the  act  of  playing  your  best  ideas  at  smallersizes during a period of suboptimal performance is a prime example of theRisk Management Investment at work, you may be surprised to read thatit  does  not  always  represent  the  best  use  of  your  risk  managementresources. I must point out that the mark of portfolio managers who havetruly  mastered  these  concepts  is  their  ability  to  nearly  always have  anabundant  reserve  of  risk  capital  available  for  high-conviction  marketopportunities.  Specifically,  by  practicing  relentless  risk  managementthroughout all phases of a trading cycle, they avoid suffering precipitousdrops  in  their  risk-taking  capacity  and  are  therefore  poised  to  takeadvantage  of  unique  opportunities,  whenever  they  present  themselves.This means setting aside a portion of their profits on all of their winningtrades, as opposed to always and immediately redeploying these winningsin the market. It means cutting losing trades before their impact extendsbeyond that of mere annoyance. It means being patient about recoveringlosses after a bad spell, and it means exercising restraint and discipline atall times. This is what great traders do.
By  contrast,  mediocre  traders  often  find  themselves  on  a  treadmill,where  they’ve  repeatedly  squandered  their  risk  capital  on  substandardideas—a problem that they frequently exacerbate by pressing their bets atthe wrong time. Then, when really good ideas do formulate in their brains,they have neither the means to put the trades on in respectable size nor thestaying power to hold the trades long enough for the sequence that theyenvision to play itself out. After the fact, they curse their luck and blamesinister outside forces for their inability to make any money, the accuracyof their predictions notwithstanding.
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I’m here to tell you that there’s very little luck involved in these situa-tions;  that  there  are  indeed  outside  forces  at  play;  and  that  you  are  notwrong  to  believe  there  is  a  systemic  conspiracy  seeking  to  ensure  thatwhen your market prospects are at their greatest, your ability to capitalizeon them is maximally constrained. This is true because portfolio managersas well as those who monitor their risk tend to operate with something ofa herd mentality. Traders often have similar thoughts about market oppor-tunity and routinely put on the same types of bets at similar times. In turn,risk managers (a breed not typically distinguished by their propensity fororiginal thought) tend to impose similar types of constraints on portfoliomanagers,  who  therefore  tend  to  effect  risk  reduction,  at  the  same  timeand in a homogeneous fashion. Many, many times this means selling at ornear  the  absolute  lows  or  covering  short  positions  at  the  top  of  theirranges.  These  risk-reducing  trades  often  leave  pricing  inefficiencies  intheir wake, and those who have carefully preserved capital (i.e., those whoare invested in  risk  management)  frequently  find  themselves  in  an  idealposition to capitalize. So when your risk management system tells you tosell your longs or cover your shorts, it is no accident that you may be mak-ing the former trades at the lows and the latter ones at the highs. And restassured that the windfall you may be handing to the person sitting on theother side of the trade is likely the result of superior risk management onhis or her part.
Examples of this “group-act” occur just about every day, embedded inmarket events both large and small. Consider the 1987 crash: Consensuswas  pretty  bullish  back  then;  and  speaking  for  my  fellow  geezers  every-where who remember this event, the timing took everyone more or less bysurprise. Anyone who was aggressively long got carried out; and for muchof that day, there were no buyers anywhere (the New York Stock Exchangespecialists  showed  themselves  to  be  especially  gallant  by  not  answeringphones and hiding under desks). So most who were forced to sell did so ator  near  the  absolute  lows.  By  contrast,  some  market  participants  wereaggressively short, and they received a very fortunate windfall. Here’s hop-ing they put some of that away for a rainy day. 
Others—those who managed its risk very carefully, trading both sidesof the market and maintaining a healthy reserve of risk capital for all con-tingencies—had  a  world-class  opportunity  when  the  market  restabilizedby  staging  an  impressive  four-month  rally  from  its  early  December  low.From there, as everyone knows, the markets were off to the races for morethan the next decade. By carefully contrasting the outcomes that befell theheathens with those of the risk management faithful, one notices an acutedichotomy. With regard to the former, not only did they probably lose theirshirts during the crash, but they also missed a chance to load up early intoa market that increased fivefold over the next decade. By contrast, those
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who minimized their damage in 1987 had investing power aplenty to catchthe wave.
There are a whole bunch of scenarios like this, playing themselves outin events dramatic and mundane. Success can be defined in terms of hav-ing the capital to risk when risk is worth taking, or at least of having thesense not to take big risks when you can’t afford to be wrong. 
Make Sure You’re Taking Enough Risk to Justify Your Trading.There are also situations when the Risk Management Investment actuallydictates the need to assume higher levels of exposures than those you arepredisposed to take. And while these are perhaps less intuitive, the impactis often no less dramatic and, as such, they bear mention. One such situa-tion occurs when the portfolio manager is operating at levels of exposureso low he or she can’t possibly hope to meet return objectives. This man-ager may believe that he or she is being prudent, but I would quarrel withthis  characterization—particularly  for  professional  money  managers,  agroup who in my experience quite often run into this problem. You are notgoing to endear yourself to your capital providers by using up their finan-cial and perhaps trading infrastructure resources in efforts that can’t hopeto produce the desired level of performance. For many of those to whomthis applies, their risk-taking deficiency may render it impossible for themto  even  cover  associated  infrastructure  costs.  And  I  have  witnessedenough of these scenarios to know with certainty that this is a conditionthat cannot last for long. Either risk taking increases, or the individual inquestion gets fired. It’s as simple as that.
Over the longer term, successful por tfolio managers also need to setaside  some  risk  capital  for  developmental  purposes,  and  this  too  can  bethought of as a Risk Management Investment. Markets are always chang-ing, and the methods that are working for you now are unlikely to sustainyou in your purpose over an investing lifetime. It is therefore prudent notonly to carefully note the changes you are observing, but also to use a por-tion  of  your  accumulated  risk  capital  to  test  new  hypotheses  and  ulti-mately to develop new strategies. In later chapters, we’ll discuss ways toestablish  clinical  parameters  for  these  developmental  efforts,  includingtiming, such that they become unlikely to cost you anything more than youare willing to expend on them, as well as methodologies for analyzing theprospects for success of these new approaches in a manner liberated fromthe natural forces of subjectivity. 
Pay Very Close Heed to Events “at the Margin.” One of the fewtruly  useful  concepts  that  the  field  of  economics  offers  is  that  decisionmaking at the margin of behavior is a key driver of economic outcomes.Examples  of  this  are  everywhere.  Businesses  produce  up  to  the  point
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where marginal revenue equals marginal cost. Consumers consume up tothe point where marginal utility and cost intersect. Because of these reali-ties, if you want to understand the economics of any situation, it pays topay attention to activity at the margin. 
How does this apply to portfolio management? In trading, success orfailure  is  decided,  more  often  than  not,  by  behavior  at  the  margin.  If  oneach transaction you strive to save yourself a few pennies on commission,achieve a tick or two better on each execution, manage your risk to slightlymore precise parameters, and conduct that extra little bit of research, youwill  achieve  a  dramatic,  positive  impact  on  your  performance.  I  promisethat, depending on where you are in your P/L cycle, this will turn good peri-ods into great ones, mediocre periods into respectable ones, and otherwisecatastrophic  intervals  into  ones  where  the  consequences  are  acceptable.Managing  these  types  of  performance  metrics  is  hard  work,  but  it  is  notnearly as difficult as losing lots of money or simply treading water. What ismore, you’ll never maximize your returns unless you factor these compo-nents  in.  Improving  performance  at  the  margins  of  your  trading  activitywill be a main theme of this book. 
Do Not Become Overreliant on Other Market Participants forComfort  or  Assistance. Blanche  DuBois  would  not  have  lastedthrough  the  first  scene  of  A  Wall  Street  Car  Named  Desire becausedepending on the kindness of strangers is the practical equivalent of finan-cial suicide (except for me—I am your friend).
Don’t Do It (Just) for the Money. Word up, brothers and sisters, ifyou’re going to be in the markets, y’all ought to try to have some fun alongthe way. No field of human activity is more competitive; and in light of this,I  believe  that  success  requires  not  just  ability  but  desire  as  well.  Morepower to those who can get juiced by nothing else than the relentless pur-suit  of  the  dead  prez.  But  in  my  experience,  those  who  operate  entirelyfrom this perspective will not only run out of steam eventually but will alsofail to capture some fundamental elements of the experience: the joy, thepride, the buzz.
Why the joy? Wherefore the pride? Whither the buzz? Because you areplaying one of the greatest games known to mankind. Because, as TeddyRoosevelt said, “In the arena,” and not a “timid soul who knew neither vic-tory nor defeat.” Because your successes and failures will be very much ofyour own making. Because without traders like you, willing to risk capitalin your belief about the value of economic assets, the world would have amuch poorer notion of what those assets were worth. Because the marketsyou trade are critical to a process that builds roads and factories and hos-pitals  around  the  world.  Because  if  you  weren’t  there  to  help  efficiently
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price  capital  assets,  money  would  flow  to  the  wrong  economic  projects,and we’d all be worse off as a result. Because no one really knows for surewhat will happen over the next five minutes, much less the next five years.Because the band is playing and your feet should be tapping. Can you hearthe beat? I can.
STRAY CAT BLUES
Brian was a very successful portfolio manager at a highly respected financialinstitution. Several years ago, he found himself in a career-defining crisis, trig-gered by a widely publicized global market disruption. Up till that time, he hadput together an amazing track record, over many years and across an impres-sively broad set of market conditions. Not only had he done very nicely in hisown right, but he had become something of an industry unto himself, with lit-erally dozens (if not hundreds) of stakeholders leaning on him for a portion oftheir  well-being.  True  to  his  nature,  Brian  bore  all  of  this  with  modest  goodspirit.  When  the  crisis  began  to  unfold,  he  was  in  the  midst  of  yet  anotherrecord year; but as fortune would have it, his portfolio was caught in the cross-fire of a hurricane that nearly engulfed the global financial marketplace.
Because  he  had  unique  market  insight,  he  not  only  saw  the  unfoldingstorm  threatening  in  its  extreme  formative  stages  but  also  recognized  itspotential  magnitude  before  almost  any  of  his  competitors.  At  the  first  truewarning signs, he started a massive liquidation, exhorting his colleagues to dothe same—all well before the contagion expressed itself in the form of a full-blown market panic. The liquidation was a very expensive process and eradi-cated  considerable  portions  of  his  profitability.  His  notions  of  a  record  yeargone (at least at that moment), he focused exclusively on the objective of cap-ital preservation. Most everyone around him was disappointed with his actions.Few had sympathy, and some of his closest supporters told him to go to thedevil. “What’s the matter with the boy?” they said “Is he checking out for sure?Is he gonna close the door on me?” Then the crisis began to unfold in earnest,and this, of course, afforded him a measure of vindication. However, as oftenis  the  case  in  market  disruption,  the  real  damage  occurred  in  intermittentphases. After the initial crisis, there was a period of calm, which nearly every-one (with the notable exception of Brian) took as a signal of a complete returnto normal market conditions. 
All through the calm period, Brian continued to liquidate his portfolio, lettingmost of his hard-won profits bleed away in the process. Some of his colleaguestried to be aggressive in the markets and encouraged him to do the same, butBrian didn’t listen to any of them. Every day, he came in and reduced his positionsize as much as he could—given the liquidity of the markets. Then the secondcritical market disruption hit. By this time, Brian was nearly flat. Meanwhile, many
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of his competitors were in free-fall liquidation mode in markets for which therewere simply no takers for the other side of these trades. Several of his comradesblew  their  careers  during  this  period.  Some  lost  nearly  all  (and  nearly  all  lostsome)  of  their  capital.  Brian  emerged,  in  the  aftermath,  with  a  healthy  level  ofprofitability still intact and ample risk capital to carry on the fight.
A story like this we would typically end right here, but Brian wasn’t done—far from it, in fact. Though still up for the year, wherever he saw red, he wasdetermined  to  paint  it  black.  He  was  way  down  from  his  highs,  and  he  wasdetermined to operate at modest risk levels until he’d recovered these losses.The process took months; and at various turns, Brian resisted the temptationto return to aggressive or even normal risk levels. He simply wasn’t going torisk another drawdown at that critical juncture. Sure, there were market oppor-tunities; but he knew that if he got very aggressive there and happened to bewrong about his ideas, he’d be back down near his lows, and he was simplyunwilling to put himself in that position.
After  several  months,  he’d  made  it  all  back  and  was  ready  to  attackwherever  and  whenever  it  made  sense  to  do  so.  As  the  fates  dictated,  therewere abundant opportunities for much of the rest of that year, and Brian endedup beating his record after all. Clearly, he had understood the value of the RiskManagement Investment.
Brian is invisible now; he’s got no secrets to conceal. Rumor has it thoughthat he’s got his trading Jones back, but I personally doubt he ever lost it. Infact, if you listen closely, you can hear the clip-clap of his feet on the stairs. 
I’d like to conclude this chapter my stating my belief that on the whole,Risk  Management  is  a  demanding  but  benevolent  mistress  who  can  andwill cause all kinds of annoyances (or worse) if she is treated with benign(or,  for  that  matter,  malignant)  neglect.  For  the  most  part,  her  demandswill  be  reasonable;  but  if  you  don’t  attend  to  her  wishes  routinely,  shewon’t be there for you when you need her most. At that point, you’ll dis-cover charms that you hardly noticed when she was hovering about you,begging for your attention. Strive to keep her satisfied while doing so is amatter of convenience and not absolute necessity. You’ll find her a stalwartcompanion. Remember, she has your best interest at heart. Make her yourregular dance partner; but be careful as to the style of music you select.She will tolerate Rap but tires quickly of it. She is leery of Hip-Hop, Grunge,New  Wave,  and  other  faddish  genres;  and  she  altogether  eschews  Punk.She’s Never Been to Spain, but she kinda likes the music. 
Above all, she loves the waltz, with its graceful, flowing lines; and shewon’t insist on leading—unless you utterly botch the job on your own. Andno matter how clumsy you are, try not to step on her toes.
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CHAPTER  2
SettingThe RiskPerformanceManagementObjectivesInvestment
Joy is at the end of hoping, Happiness is there some days, Jesus told me I’m a spaceman, and I believe in every word he says.
—Shawn Phillips
So what is it that you’re trying to accomplish in the markets anyway?
Have you given it much thought? Perhaps you should, and maybe Ican help frame the question. For rhetorical purposes, we’ll continueto  assume  that  your  goals  have  something  vaguely  to  do  with  makingmoney;  but  now’s  the  time  to  move  beyond  glib  generalities.  Remember,we’re  talking  about  investment here,  which  implies  the  allocation  ofscarce resources—by which I mean resources that I’m assuming you can’tafford  to  squander.  Further,  because  the  risk  management  elements  ofinvestment add an additional layer of complexity to what is already a com-plicated process, establishing methods to evaluate performance becomesan even more critical prerequisite to success.
On the one hand, we know that our goal setting must extend beyond ageneral  commitment  to  trade  profitably.  On  the  other  hand,  we’ve  gotenough inputs (or will have, within a couple of chapters) to create, if wewere so disposed, a mosaic of objectives of self-defeating complexity. 
Recall, if you will (and for those who haven’t encountered it, I suggestyou amend this error quickly), the Byrds song “Chestnut Mare.” In it, thesinger talks about catching a horse, but not just any horse, one that he him-self could befriend for life. This is one way of thinking about the task ofsetting your portfolio management objectives.
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What kind of horse are you going to catch (if you can)? If you are likeme, you’ll agree that the question is an important one that should take intoaccount all contributing factors.
Let’s start by identifying the following critical constraints: 
• Market  conditions  are  both  dynamic  and  unpredictable.  Sometimesthey’re good and sometimes they’re bad; and it’s very difficult to knowone  from  the  other—at  least  until  after  the  fact.  Conditions  alsochange rapidly and without warning. 
• Market participants have finite resources, most notably those associ-
ated with time and the ability to sustain losses.
Given, then, that you are operating with limited resources in a universewhere the quality of the environment is difficult to measure and constantlyshifting, I believe that your goal setting must take into account a numberof possible outcomes. At one end of the spectrum, there’s certainly noth-ing  wrong  with  thinking  expansively,  and  I’d  be  the  last  to  argue  againstsetting ambitious objectives simply because difficult obstacles may standin the way of your attaining them. However, part of your planning shouldalso reflect the fact that the markets themselves may limit your upside andthat no set of objectives would be complete if they fail to contemplate cap-ital preservation under difficult if not disastrous circumstances.
To reinforce these points, I recommend the setting of not one but three
sets of objectives:
1. Optimal  Target  Return. This  is  the  amount  of  profit  that  you  areshooting for if everything (i.e., external market conditions and internalaccount management) goes right. Your profit figure should typically behigh enough that you will have to stretch your skills to reach it, but notso high as to be inherently self-defeating. 
“Too low they build, who build beneath the stars,” said the Englishpoet Edward Young in Night Thoughts. I’m not sure that this is alwaystrue  for  the  science  of  portfolio  management  and  trading;  but thenagain, maybe I’ve been on the risk management side of the business fortoo long.
2. Nominal Target Return. This figure should be fixed at the amount ofrevenues that you feel confident you can achieve under almost all mar-ket circumstances and below which you will acknowledge that some-thing may have gone wrong with your plan, thereby allowing for sub-sequent critical analysis.
3. Stop-Out  Level. Perhaps the most important parameter of all, thisfigure  is  the  amount  of  loss  at  which  you  commit  to  a  complete
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liquidation of your portfolio—and is a figure that you must commit notto exceed.
Because these objectives will serve as critical benchmarks, not only injudging overall performance but also in terms of evaluating the efficiencywith  which  you  are  managing  your  resources,  I  discuss  each  in  furtherdetail.
OPTIMAL TARGET RETURN
Another  righteous  English  poet,  Robert  Browning,  said  (in  Andrea  DelSarto), “Ah, but a man’s reach should exceed his grasp, or what’s a heavenfor?”  Each  year  (or  other  applicable  period  of  your  own  choosing),  it’salmost certainly a good idea to set a performance goal that is sufficientlyaggressive  as  to  represent  a  major  accomplishment  if  you  are  able  toachieve it. While this might raise a few eyebrows among my brethren atthe  Temple  of  the  Risk  Averse,  I  am  willing  to  accept  their  derisionbecause I feel that the setting of an Optimal Target Return is an ideal start-ing point for the formation of a plan of attack for any upcoming tradingcycle.
If  you’re  going  to  be  at  your  best  in  this  difficult  project,