And while traders aren’t gamblers per se, a similar thing happens in the market. In the real world, cash is a scarce and valuable commodity. But once the check is written and sent to Schwab, hard-earned money becomes, at least in our minds, a stack of chips, ready to be anted up at the nearest table.

And when a click or keystroke can mean thousands of dollars, a fully funded brokerage account feels like Harrah’s on your hard drive. From the craps table to Comverse Technology (CMVT), it’s much easier to lose big money when you’re not thinking about the money.

So no matter at what level you play the game, you’ve got to get in the habit of keeping it real. In my experience, the best traders aren’t gun-slinging gamblers, but pragmatic realists. They’re better at seeing the world the way it is rather then the way they’d like it to be.

The game is called absolute return and it has but one rule: Don’t lose money. So amid the slew of research reports and pundit prognostications, we can’t forget that we’re playing with real dollars, not casino chips. Every trade has risk, and even so-called defensive stocks can get whacked. Good traders tell it straight. They are experts at distinguishing between what is possible and what is probable. They know themselves just as well as they know the markets. In the futures world, keeping it real means that accounts are marked to market. The value of your portfolio is settled in full each night. Losses are debited, gains credited. There is no such thing as a “paper loss.” Although this is a foreign concept to equity investors conditioned to wait around for the long haul, this is exactly how you should approach your stock portfolio.

As much as it hurts to admit it, a paper loss is still a loss. What matters isn’t what price you paid for Nortel Networks (NT), but where it’s trading now, how much of it you own, and what effect the position has on your overall portfolio. Don’t kid yourself into thinking that a loss isn’t a loss just because you haven’t seen fit to take it yet. As a trader, you’ve got to assess your portfolio as it is today — not as it was last week, last year or the last time Tom Galvin reminded us how bullish he was.

But keeping it real means not only determining what you have, but how much you are willing to lose.

In allocating a portfolio, financial professionals use the terms “volatility” and “risk tolerance.” What the heck do those mean, anyway? After all, nobody minds volatility as long as it’s on the way up, and everybody’s risk tolerance is high so long as returns are. So instead of qualifying the possibility of losses, try quantifying them in your own account. When it comes to controlling risk, concentrating on your portfolio’s drawdown lets you determine your pain threshold, right down to the dime.

Drawdown simply refers to the percentage decrease in your account. If your $100,000 shrinks to $70,000, you’ve experienced a 30% drawdown. Unlike the ambiguity of “risk tolerance,” drawdown cuts right to the chase. You’ve just taken a 30% loss. At what point does that pain grow severe enough to warrant some changes?

So draw a line in the sand. Decide in advance how much of your account is in “chips” — money you can stand to lose — and how much is in “savings” — money you can’t bear to part with. So let’s say you’ve got a $100,000 account and have determined that, no matter what, you don’t want to see your equity drop by more than 20%. Then let’s assume the worst: While you diversified and hedged as a means of reducing risk, the sky falls in for whatever reason and your self-imposed drawdown limit is reached. Now you’ve got $80,000.

Should you hope things improve and wait for the bounce back? Not in my book. Don’t be an optimist, but a realist. Take some losses, reduce your level of exposure and call a retreat.

A final trick for keeping it real. Every couple of months, I get a hundred dollars in cash and treat myself to a few of my favorite trinkets. I buy a new CD. Or an art book. I’ll buy insanely sugary cereal or a high priced bottle of wine. I find an affordable indulgence and pay for it…in cash. Over the next few weeks, you should give it a try.

The point is to reacquaint yourself with money and its meaning. There are very few times when we must actually use the good old American greenback these days. Most of us rely on plastic, checks or account numbers to store the medium of money. Carrying cash is almost quaint; even the IRS takes credit cards now. And as a trader, chances are you don’t request a check every time you pull the trigger on a winning trade.

So get a big wad of cash, preferably in singles, bring it home and play with it. Ruffle the bills. Count them “Price-is-Right” style on your desk. Fold them every which way. Smell the cash. Feel it. Hold it up to your face.

Unlike chips in a casino or numbers on the screen, cash exists in reality. Put it in your pocket and reacquaint yourself with the delightfully dangerous feeling of having money to burn. A hundred bucks in cash feels like real money, doesn’t it? And yet most of us would drop 10 times that in an instant on the market and not even blink an eye.

That’s what I mean about making it real. While money can’t buy happiness, it’s a wonderful feeling to know that, from gourmet coffee to a first run film, a whole lot of enjoyment can be squeezed out of a measly hundred bucks. Buying something with cash is an easy way to remind yourself just how good money can feel, and how much it matters. I want you to remember that feeling the next time you want to double down on some dog with fleas or bet half your portfolio on a single punt.

– Originally on Jul 12, 2001 by Jonathan Hoenig

For many of us, cash comes in the form of a money-market account, usually either linked to a brokerage account, bought from a mutual-fund company or sold by a bank. Only bank-sold money-market funds come with FDIC insurance, but all suit the same general investment goals: safety and high liquidity. They are essentially savings accounts — and they’re more for peace of mind than for profit. The problem with money-market accounts is that, in exchange for liquidity and protection of principle, we forfeit the higher returns that come along with even slightly more risky investments. For example, E*Trade Group’s (ET) money fund currently yields 3.7%. Fidelity’s is in the high 2% range. Not exactly champagne wishes and caviar dreams.

But with sound cash management, you can do better. You manage a cash portfolio just as you do a stock portfolio. Using appropriate position size, money management and risk controls, you can improve results with only marginally higher levels of risk.

As I wrote last week, traders have a tendency to suffer from “all or none” thinking. Either they’ve got 100% of their money in Cisco Systems (CSCO), or all of it stuffed under the mattress. But you can shoulder more risk without being reckless. You’ve got a money-market fund, and that’s great. Now spice it up. Throw in some emerging market debt or closed-end junk. From riskier bonds to longer dated certificates of deposit, there’s an opportunity to diversify.

Compared to the hallucinogenic returns of years gone by, squeezing a few extra tenths of a percentage point out of your cash might not seem that significant from month to month. But over time, it can really add up. Let’s assume you’ve got $10,000 set aside for long-term, low-risk savings. Over a 25-year period, the difference between a 3% compounded annual return and a 4% annual return is staggering. If you earn just 3%, you’ll end up with $20,937, but 4% garners $26,658. Average 4.5% over that same period, and you’ll bank $30,054. That’s 83% more return on “just” 1.5% extra juice each year.

This is what’s really behind the “long-haul” rhetoric that we so often hear as a reason for owning stocks. The power lies in the mathematical effects of compound interest, not in equities as an asset class. Even low levels of investment return make money grow exponentially when allowed to consistently compound over time. No wonder Ben Franklin called compounding “the eighth wonder of the world.”

One lay-up in the search for higher yields is certificates of deposit — which, depending on the term, are now paying significantly more than money-market funds. Bought through a bank, CDs offer FDIC insurance, no commissions or brokerage fees, and pay a fixed rate of comparatively high interest. For example, as of early July, the top one-year CDs are paying 5%. Longer-dated maturities pay even more.

The hook with CDs, of course, is that there is no liquidity. Certificates of deposit come in maturities ranging from one month to five years or more — but in exchange for higher interest, you give up the right to get to your money. Unless you pay a hefty early-withdrawal penalty, CDs are essentially “locked” until they mature. Personally, when it comes to saving money, I find the “no withdrawal” policy more of a help than a hindrance: It’s harder for me to spend money when I can’t get at it.

Like money-market funds and CDs, the other instruments you’ll use for cash management are all debt of one form or another. So in managing your cash, you are really a bond trader, and while stocks get all the glory, the biggest and most important market in the world is the bond market.

In this market, “buy low, sell high” is reversed: The idea is to lock in high rates before they go lower and avoid getting stuck in low rates as they go higher. A year ago, for example, the yield on the benchmark 10-year government bond was 6%. Now the same bond pays in the low 5% range. There are dozens of high-quality bond funds that can boost your overall return. The main consideration here is duration. Long-term bonds are more sensitive to changes in interest rates, and if rates spike, these funds will tank. So despite their “safe” image, it’s possible to lose money investing in a bond fund.

And some bond funds are clearly riskier — and potentially more rewarding — than others. Emerging-market bonds funds are poised to become the sleeper hit of the year. They are up 8% year-to-date, 5% in the second quarter alone. Despite some volatility, high-yield or “junk” funds are also hanging in. The low cost Vanguard High Yield Corporate fund (VWEHX) is up a respectable 2% year-to-date. Convertible bond funds are outperforming, too. But remember: These are much riskier propositions than money-market funds or CDs. Like extremely strong seasonings, they should be used judiciously to spice up your cash portfolio.

So there’s more to “cash” than a money-market fund. So pick a benchmark — say the Lehman Brothers Aggregate Bond Index — and see if you can beat it. Allocate 5% here, 10% here. Keep more cash than you need on hand. Don’t aim for home runs, but consistent singles. Risk, not recklessness.

– Originally on Jul 05, 2001 by Jonathan Hoenig