Money Management in Forex : The Great Importance of Moral Hazard

Through the rest of this week I will start introducing my project to help Asirikuy members become money managers. The aim of this project is to help Asirikuy members gather their own “trading group” and therefore decrease the time needed to achieve “trading for a living”. On the posts that will come up within the next few days I will explain what this project is all about, what its main objectives are, how it will help us establish a money management community and track record and how it will allow us to get clients in a legal and safe way. However on today’s post – before explaining the underlying aspects of the project –  I will discuss with you a very important issue of money management which is moral hazard and manager’s responsibility and ethical behavior.

As you all may know, money management is simply a practice where a person invests another person’s money with the objective of giving that person a certain level of return. In exchange the manager – who performs all investing operations – receives a percentage of each profit (a performance fee) and sometimes even a yearly percentage of the person’s money regardless of the results (a management fee). In the investment community the “standard” has become to charge a 20% performance fee plus a 2% yearly management fee of all assets under management.

The problem here comes when you consider the manager’s advantageous positions. The manager has only money to win (as performance fees) as no losses are incurred by the manager if the investor losses all or some of his or her capital. This in the real world has always encouraged money managers – or at least a certain type of them – to take excessive risks in the hope of getting very high returns they can get a commission on. When small amounts of money are involved this might not be an extremely important issue – as the manager’s reputation is more important than what he or she can get from excessive risk – but when larger money comes into play it is important as the manager can make enough money in commissions for the rest of his/her life before ruining the investors. If a person is overseeing a 10 million dollar account, it is perfectly possible for the manager to make 30 million in a year (netting him/her  6 million in commission) wiping the clients’ accounts next year. The manager has enough money to live for the rest of his life, the investors have nothing.

When a manager invests capital seeking return only for the sake of his or her commission, we get  what we call moral hazard. The manager is behaving in an unethical manner which is unknown to the clients, the manager is in fact doing his or her clients “wrong” -at least in the long term- by ignoring risk for the sake of his or her personal gain.

For this reason I believe that money managers should always keep all their performance and management fees (if any) on the same investment account as a client’s and only withdraw them to the same proportion as the client does. This ensures that if the client wipes 30% of this account, the manager wipes 30% of his/her profits and if the investor losses 100%, the manager losses 100%. This is part of what I call “responsible managing”, the practice of managing money putting only the client’s money first along with adequate capital preservation, the practice of handling a client’s money as if it was your loving grand mother’s pension fund after 50 years of hard work.

I think that it is vital to have some basic moral principles in money management which ensure that a client’s capital is handled in a very careful and thorough way. In summary you can say that I manage accounts with all the following things in mind :

1. The amount of risk the client takes with his/her profits is the same as mine or smaller. I only withdraw profits if the client does the same thing in proportion so that the withdrawal constitutes the same percentage of the client’s withdrawal as the performance fee.

2. I don’t charge management fees. I believe that gain needs to be tied to performance. There is a strong ethical reason to do this since charging management fees implies that the manager gets his cut, even if he/she shows absolutely no profits.

3. The client should ALWAYS know worst case targets and system statistical information. It is vital for the client to know exactly what to expect from your trading. What sort of yearly performance you’re aiming at, what risk per trade, what type of diversification, what average draw down period length, depth, etc. It is extremely important for the client to realize that certain draw down levels WILL happen in the future and it is very important to communicate all this information in a CLEAR way. The client should realize that yearly profits have a certain standard deviation and that certain losing years (depending on the strategy used) might happen. If a client knows what you are doing from A to Z it gives him or her confidence in your seriousness and professionalism as a trader.

4. The client should understand all the risks. Clients should now that the risk of a 100% loss is possible under certain circumstances. For example the client has to know that if a 1000 pip gap happens beyond your stop loss the account will be wiped. Even though such events have never happened, it is always a good practice to inform customers about the basic risks of the market. A good practice is to personally READ with them the risk statements and contracts they sign when they open an account. Total understanding of trading terms is VERY important.

5. No introducing broker or other broker related ties. I believe that a manager cannot behave in a truly ethical way if he or she gets any money on a volume per trade basis. This means that a money manager should have absolutely NO ties with the broker either as an introducing broker, spread rebate referral, etc. This may motivate the manager to trade a lot, even if this implies a larger risk. This is the main reason why I have never used – and do not intend to use – account management services such as tradency and Zulutrade. In my view, ethical management requires the profit of the manager ONLY to be tied to account performance.

As you see, ethical behavior for me plays the foremost role when managing a person’s capital. It is all about educating the client about what you are going to do with his/her money, the risks implied and the potential gains within the picture. It is about eliminating moral hazard and being responsible for a person’s money knowing that your profits/losses will affect another human being. It is not about maximizing your returns as a money manager but about following what the client wants to achieve with his or her money and charging a commission for this achievement. If you do your job you get paid, if you don’t then you don’t. This makes you do your best as a manger to improve your trading systems, strategies and to improve your risk management.

During the next few days I will introduce my Asirikuy money managers project where we will start a very interesting journey towards building a community of money managers with a public track record, ethical behavior, etc. If you would like to learn more about my work please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach to automated trading in general . I hope you enjoyed this article ! :o)

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