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Mathematical Role Models

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Whether you are an aspiring risk manager, quantitative analyst, or a trader, your first order of business is to manage risk. Fundamental analysis can tell you what a company is worth or whether a sector is undervalued theoretically, but market prices and volatility have their say also. You come to find that entries and exits are important, but ultimately risk management comes down to position sizing.

From there you can purchase expensive backtesting/simulation software and a subscription to the data that you need to run through it, but unless you have been trained in what all the boxes you've checked before you click "Run" mean, you will likely have data mined and over optimized your way to hypothetical success.

At various times of my career I have used such simulation software. Admittedly, it is very helpful and still is in some ways. It is very fast in its calculations and can also run Monte Carlo simulations for you, for example. However, nothing will replace the knowledge you will get from having to learn to do it from the ground up. I have done that too. My first model was created by hand on spreadsheets: first Lotus 123 cum Excel.

Constructing a portfolio that will provide you and your clients with the best risk-adjusted returns, while suitably diversifying your holdings, is done by teams these days. Teams that have a great deal of resources and intellectual capital. You need to learn how to construct such a model in order to compete in the global marketplace that is seeming to become more and more uncertain each day, perhaps by yourself at the beginning. It may appear to be easy in theory, but it is much harder in practice. One of the best things you can do to get started in an affordable manner is to become very proficient in Excel.

Quantitative hedge funds (Quant funds), such as AQR and Renaissance, spend enormous amounts of time, money, and effort to make sure they sift through oceans of data to find the most profitable opportunities. They also invest in the best personnel...many of whom have PhD's in Quantitative Finance or hold designations such as the CQF (Certification in Quantitative Finance). The competition is brutal, and this is before you have to fight off the high frequency traders...

Successful risk managers know the limitations of VaR, the Kelly formula, and CAPM. As Aaron Brown, Risk Manager of AQR wrote in his new book, Red Blooded Risk, "Successful risk taking is not about winning a big bet or even a long series of bets. Success comes from winning a sufficient fraction of a series of bets, where your gains and losses are multiplicative.

In order to get to the place where you can affect such trades, you need to test the data. I believe that this is best accomplished these days in an affordable manner using Excel. Thankfully, Excel has dozens of built-in mathematical functions that which can utilize advanced techniques that can give you the answers you need with the statistical significance to boot.

Without these answers, you will not have the emotional nor statistical confidence to manage the risk, nor will you have the answers to the questions that are frequently being asked in today's environment: "What happens if....?"


–Michael Martin

Michael Martin has been a successful trader for over 20 years. He is the creator of "Martin Kronicle," author of The Inner Voice of Trading, and instructor of the NYSSA Certificate in Commodity Trading & Trend Following.

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