The Massive Hidden Costs of Not Scaling Up Trade Size

Scaling-up trading size is one of the most contentious and challenging issues I have come across in my work coaching traders. Whether it is private traders working for themselves, or Hedge Fund managers running hundreds of millions of dollars in capital. 

Scaling up refers to the increasing of risk or trade size as your capital grows. (Equally, and not forgotten, scaling down refers to reducing size to conserve capital following losses, however for the sake of this article, I am focusing on 'Scaling-up'). 

The purpose of scaling up is to ensure we use our capital most productively in light of positive expectancy which results applying a system, method or approach. 

Imagine a trader starts with $100,000 of capital in year 1. After trading costs and living costs they earn a return of 15% or $15,000. Their risk sizing approach may be based on a certain trade or lot size, or some formula such as willingness to risk a certain percentage of capital, or perhaps the Kelly Criterion. At the end of year 1, the capital will be $115,000. 

In theory, the trader can now increase bet-size by 15%. However, many people are cautious of stepping up in size. - They fear as they do this, they may face a loss, and given the increased size, their loss will erase last year's profits. They also fear their mindset will be impacted by the larger size. As such they often keep the same size. 

The danger is the same happens the next year, and over time this becomes a repetitive pattern year after year.  

There may not seem too much danger at first in doing this. Indeed, if you look at the chart below, which shows capital growth based on the above parameters for a 7 year period, visually the damage does not seem too bad. Maybe you are happy to accept this for the peace of mind this brought. - Fair enough.

However, in terms of numbers, the difference is $60,000, almost 60% of the original capital. - Ouch, now it matters. - And this is only the start. - Imagine this continued to play out over a trading or investing career of 30 years. 

The next chart shows this extrapolated with the same assumptions for a full 30 years. 

Now it really matters!!

After 30 years, the capital based on scaling up every year on reinvested profits, (assuming you averaged an annual 15% return after costs), would equate to just over $6,600,000. Whereas not reinvesting, and not scaling up, would equate to a capital value of $550,000. A mere 8% of the capital on the scaled-up calculation. 

Before you start taking apart these numbers, I am fully aware there are a ton of what-ifs, other assumptions, and non-accounting for interest, (Which let’s face it, is not very much at best these days). But that misses the central point here. There is a huge opportunity to not scaling up. - A massive 'Output Gap'.

The reason for not scaling up is always emotional. The rational case has been made, the emotional however effects are not easy to deal with. Just yesterday I made note of a quote from the legend that is Howard Marks on a Shane Parish podcast interview. 

‘Our emotions conspire at every turn to get us to do the wrong thing.’

Few things highlight this more graphically than the above example.

There is no simple answer to this, I have worked on this challenge for many years with many clients. It keeps revealing itself in many ways. From traders who are consistently profitable, but not able to increase their size, to hedgies who are achieving great returns on capital allocated but underusing the full capital they are given. I have seen it effect Portfolio Managers who have had their Asset Allocation increased, but then failed to adjust their risk size, to systematic trader who having proved the value of his systems but then feared upping the risk size for fear it would fail on the new size. Paradoxically the same issues as discretionary traders! 

Scaling up size is a deeply emotional issue, which brings out a person's 'loss-aversion' and represents a massive opportunity cost. 

Article by Steven Goldstein 

Steven Goldstein is a Performance, Team and Executive Coach who focuses on Risk and Financial Markets people and businesses.

Core to Steven's work is the belief that everyone has the potential, often latent or hidden within them, to surpass where they are now and to grow into what they want to be. His work as a coach helps people to rediscover that potential, to recognise it, to value it, and to leverage it to be better, happier, and more productive.

Prior to becoming a coach Steven worked for more than 20 years as a Rates and FX trader at some of the world’s leading investment banks. See Steven's Full Profile.

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