Square root rule / Money management for portfolio components

Posted By: flip26

Square root rule / Money management for portfolio components - 10/20/21 17:35

Hello everyone,

I have read the Black Book, and understand the rationale of he square root rule as it applies to reinvesting profits in highly leveraged systems.

My question relates to the Zorro web page (https://manual.zorro-project.com/optimalf.htm):

In a multi-asset system, what is the rationale of taking the square root of the number of components?

Code

// multi-asset system: reinvest the square root of profits separately per component and long / short trades
var AvailableCapital = Capital/sqrt(NumComponents);
Margin = ifelse(ForLongTrade,OptimalFLong,OptimalFShort)*AvailableCapital*sqrt(1+(WinLong-LossLong)/AvailableCapital);

To be clear, if I have a 5 component system, why can't I allocate AvailableCapital as:

Code

var AvailableCapital = Capital / 5;

Thanks!

Posted By: Zheka

Re: Square root rule / Money management for portfolio components - 10/21/21 10:41

Trading a portfolio of uncorrelated 'components' allows to be somewhat more aggressive with sizing - hence 'the square root of components' .

Posted By: flip26

Re: Square root rule / Money management for portfolio components - 10/21/21 11:57

Ahh, that makes sense. Thank you.