Is it true that you can't take money out of the market using only risk management?

Question

Is it really true what a lot of traders say: that in order for you to make money in the stock market it suffices to use risk management?

For the following reasons, I think it is not true:

Suppose you have a 1:2 risk reward ratio meaning that for every 1 dollar you are risking to lose you may win 2.

Suppose the stock price is 10 and you either lose 2 or win 4 in accordance with the aforementioned risk reward ratio.

The fundamental issue here is that you have more chance of losing 2 than winning 4. In the long run you will have no profit.

You can better understand this with the following reasoning:

There is 50% chance that the price will rise to 14 and 50% chance that the price will fall to 6, this anyone would agree. If it were possible to see all the possible price paths that would lead the price from 10 to 14 you would see a lot situations where the price would firstly fall back to 7 and then rise to 14. When you put an assymetric risk reward ratio like 1:2 you're cutting off those price moves which would lead to 14 so your chance is really smaller of getting to 14.

Thus, it does not seem to me that you can simply can't take money out of the market in the long run using risk reward management.

You can repeat the risk management procedure some times and it seems to work, but in the long run you will give all the money back. That is what statistics tells us.

Is my analysis correct, or have I missed something?

Answer 1

I suspect what you mean by "take money out of the market" is obtaining returns above the market average, i.e., "beating the market". Indeed, your intuition is correct that unless you can statistically predict stock returns better than the "random walk" model, you cannot beat the market just by applying "risk management rules" like profit targets or stop losses.

The deep reason for this is the optional stopping theorem, which says that there is no winning strategy for betting on fair coin flips -- or more generally, on similar processes known as martingales. The random walk model describes the deviations of stock returns from the average return as martingales, so the implication is that there isn't any successful "market timing" strategy for benefiting from these deviations.

Answer 2

There is 50% chance that the price will rise to 14 and 50% chance that the price will fall to 6, this anyone would agree.

No, absolutely not. The chance of the price going to 14 is significantly greater than the chance of the price going to 6.

Is my analysis correct, or have I missed something?

What you've missed is the fact that on average, stocks are profitable.

The reason for this is that on average, business is profitable. If I buy an apple orchard, then the value of the apples it produces will probably be greater than the cost of the labor, machinery and supplies needed to grow the apples. The same goes for all kinds of business: on average, business activities produce more value than they consume.

It's a gamble, but it's a gamble where the investor has the edge. In the long run (say, over the course of 40 years), the risks are pretty small relative to the rewards.

Answer 3

You need an edge to make money over long term.

Proper risk management will increase your sharpe ratio and protect against bankruptcy. Even with a strong edge you can go bankrupt without proper risk management.

Ways of risk management is diversification, stops and not having too high leverage.

Answer 4

The one armed bandits in Vegas are programmed somewhere near a 40% payout. During a short period of play, you may win, you may lose because it's a finite sample. Over the long haul, the house wins.

It's the same with your hypothetical set up. If the odds are even that "you have a 1:2 risk reward ratio meaning that for every 1 dollar you are risking to lose you may win 2" then you will make money. There's a positive expected return.

However, your contrived set up has nothing to do with risk management. You have described the risk of the bet not its management.

Risk management means just that. You do something actively to reduce risk. It could be using stop orders (and hoping that there are no gaps).

In the world of options, a risk management example would be rolling long calls up as they become profitable, booking gains and reducing cost basis (risk management). Or selling OTM calls against those long calls. Or buying some puts after the run up to lock in gains. All of these actions lowered the risk.