Money management the process of managing money which includes investment, budgeting, banking and taxes. It is also called investment management.
Money management is a strategic technique employed to make money yield the highest interest-yielding value for any amount spent. Spending money to satisfy cravings (regardless of whether they can justifiably be included in a budget) is a natural human phenomenon. The idea of money management techniques has been developed to reduce the amount that individuals, firms and institutions spend on items which add no significant value to their living standards, long-term portfolios and assets. Warren Buffett, in one of his documentaries, admonished prospective investors to embrace his highly esteemed "frugality" ideology. This involves making every financial transactions worth the expense:
1. avoid any expense that appeals to vanity or snobbery
2. always go for the most cost-effective alternative (establishing small quality-variance benchmarks, if any)
3. favor expenditures on interest bearing items over all others
4. establish the expected benefits of every desired expenditure using the canon of plus/minus/nil to standard of living value system.
These techniques are investment-boosting and portfolio-multiplying.
Trading and investment
Money management is used in investment management and deals with the question of how much risk a decision maker should take in situations where uncertainty is present. More precisely what percentage or what part of the decision maker's wealth should be put into risk in order to maximize the decision maker's utility function.
Money management can mean gaining greater control over outgoings and incomings, both in personal and business perspective. Greater money management can be achieved by establishing budgets and analyzing costs and income etc.
In stock and futures trading, money management plays an important role in every success of a trading system. This is closely related with trading expectancy:
“Expectancy” which is the average amount you can expect to win or lose per dollar at risk. Mathematically:
Expectancy = (Trading system Winning probability * Average Win) – (Trading system losing probability * Average Loss)
So for example even if a trading system has 60% losing probability and only 40% winning of all trades, using money management a trader can set his average win substantially higher compared to his average loss in order to produce a profitable trading system. If he set his average win at around $400 per trade (this can be done using proper exit strategy) and managing/limiting the losses to around $100 per trade; the expectancy is around:
Expectancy = (Trading system Winning probability * Average Win) – (Trading system losing probability * Average Loss) Expectancy = (0.4 x 400) - (0.6 x 100)=$160 - $60 = $100 net average profit per trade (of course commissions are not included in the computations).
Therefore the key to successful money management is maximizing every winning trades and minimizing losses (regardless whether you have winning or losing trading system, such as %Loss probability > %Win probability).
Ethical or religious principles may be used to determine or guide the way in which money is invested. Christians tend to follow the Biblical scripture. Several religions follow Mosaic law which proscribed the charging of interest. The Quakers forbade involvement in the slave trade and so started the concept of ethical investment.
- Harris, Michael (May 2002). "Facing the facts of risk and money management" (PDF). Trading Strategies (Active trader). p. 33. Archived from the original (PDF) on 2006-10-17. Retrieved 2006-11-19.
- Gomez, Steve; Lindloff, Andy (2011). Change is the only Constant. IN: Lindzon, Howard; Pearlman, Philip; Ivanhoff, Ivaylo. The StockTwits Edge: 40 Actionable Trade Set-Ups from Real Market Pros. Wiley Trading. ISBN 978-1118029053.