What do you suppose would be the impact on your professional and personal life if for your whole life you were illiterate, and then one day learned to read? I’m not just talking about reading with speed and accuracy, but being able to comprehend better than ninety percent of the population in the world. Do you think that would make a difference?
Most people would say yes, realizing this would be a life changing event for them. But what if we were talking about investing? If you could learn how to invest better than ninety percent of the investors in the world, do you think that would change your life for the better?
If the answer to this question is yes, then I am going to make you a promise. If you pay careful attention to some simple steps and commit to following the risk management rules outlined in this article, then you will do better than ninety percent of the investors who put their money at risk in the market.
The most important thing that I have learned in my twenty six years in the industry as a professional trader is that the main difference between the successful investor, and the unsuccessful investor, is that successful investors have learned how to minimize their losses when they are wrong. Think about this for a moment. If you were able to go back in time and eliminate two or three of your biggest losses, how far ahead would you be in your investments today? Right about now you might be saying, “Eliminate two or three of my losses? Heck, I’d be happy if I could eliminate my single biggest loss.”
I’m sure everyone has made at least one mistake with regards to managing their own finances, but the reason most people do a poor job investing their money is that they have a bad habit of holding onto their losses for too long. We are emotional beings, and when we suffer a financial loss the tendency is to run and hide. Yes, we bury our heads in the sand hoping that things will get better and when they don’t, we try very hard to avoid the loss. If you think I am just talking about the stock market, you are mistaken. This happens with real estate, personal finance, and believe it or not, it happens in personal relationships too. People say to themselves, “I know things are not feeling quite good right now, but with a little time, things will get better.”
The sad thing is that most of the time when you hold on to a bad investment things usually get worse before they get better, and if you hold on too long you may wind up risking more during this holding period than you originally planned for.
Take a drive around your neighborhood tomorrow and count the number of homes that have recently gone into foreclosure. Chances are those homes are owned by individuals who knew they were in trouble long before their homes went into foreclosure, but decided to hold on. This is a very painful position to be in and of course there are many other factors that can come into play that might bring about the foreclosure of a piece of property, but when it comes to investing in the stock market the signals are exactly the same.
The first sign of a bad investment is when you get that sick feeling in your stomach. Things just don’t seem right, but instead of closing out of this bad investment, most people hold on with a “wait and see” attitude. The fact is you should listen to your stomach because if you are stressed out about an investment, chances are you will not be making the best decisions about your money and on top of that, the added stress could take its toll on your health.
Woman do a much better job limiting loss than men do, which is why women make better investors overall. It’s true, women generally do not like to put their money at risk while men will not only take more risk but will also fight the market when things turn against them. Many times men will even buy more of a stock as it drops hoping to cost average down, with the thought that this is a good strategy. “Cost averaging down” is actually a corrupt form of dollar cost averaging, which is more of a long term strategy used in retirement accounts that are invested in mutual funds. If you consistently cost average down in stocks that are hurting you, then it’s only a matter of time before you blow up your entire investment portfolio. Some of the saddest stories come from those who bought stocks like Lucent, WorldCom and, more recently, Bear Sterns.
Before I get all of the guys after me for bashing their investment skills, let me also say that men do a much better job of holding on to the winners. Women will generally exit an investment sooner than a man would as they are happy to be able to take a profit. But taking profits too early can cost you big profits down the road, especially when those stocks are showing strong upward trends.
Now, if we could combine a man’s ability to “let the profits run” with the risk management skills most women possess, we would have a perfect trader.
Managing risk is not as hard as you may think. It really comes down to a simple mathematical formula that can help you calculate the risk amount before you even get into the investment. Good money managers will only tolerate a certain amount of loss before they close out of a particular investment. This loss tolerance is calculated in percentages call “the draw down”. For you, the individual investor, this loss amount should also be calculated in percentages. What I am talking about here is not a percentage based on the share price of a stock, but a percentage of the overall portfolio.
If you are a short-term stock trader, I would recommend a percentage of loss that is no more than one percent. This is what we call “The 1% Rule”. Let’s use a $100,000 account as our model so I can show you how this works.
Account value = $100,000
1% of this amount = $1000
The 1% value represents the loss amount. In other words, it is the amount of money we would tolerate as a loss to our account before we would close out of the losing position. Using this 1% Rule also helps us to calculate the amount of shares we would buy, which is call “sizing the position”.
Another mistake investors make is that most will guess at the number of shares to buy. If you have $100,000 in an investment account, you shouldn’t feel compelled to randomly spend all of that cash on stocks just because you have a feel for the market or because a certain analyst you liked made a buy recommendation. The fact is, those analysts could care less about your account and there is a good chance they will not be calling you when it’s time to sell that stock, once it has gone bad.
If you are a trader who is using The 1% Rule, then you will also be able to give your stocks room to breathe during times of high volatility. If you think about it, you can still let a stock drop 5, 10, 20 percent or more in price before it’s time to get out, it just depends on how many shares you buy.
If, in your $100,000 investment account, you buy 1000 shares of a $20 stock, you can let that stock drop 5% (or $1) before you lose your $1000 risk amount. But if you buy 200 shares instead, you can let that stock drop 25% (or $5) before you lose your $1000.
I should mention that using technical analysis will help you determine where support is for your stock, which will dramatically increase the probability of you making a profit. This is because our exit points should be somewhere below key support levels. We don’t want to buy or hold a stock once it has broken down below a key support level because this is a sign that the buyers are giving up on the stock.
If you are not familiar with how to determine key support levels when looking at a chart, then just stick with me as I outline these ideas for you in future articles. Many people have asked me how they can use charts to determine where a stock is going to go and they are often disappointed when I tell them that I don’t use charts to predict the future. It’s true. I simply use them as a tool to manage risk.
If you are more of a long term investor, you may want to adjust The 1% Rule to allow for more dramatic price swings in your portfolio, and there is nothing wrong with using a 3% Rule for investments that include Mutual Funds, Exchange Traded Funds (ETFs), foreign currencies, or precious metals. The important thing to remember is that you should pre-calculate your loss amount before you enter the position. This will not only help protect against a catastrophic loss, but will also help eliminate the stress associated with managing your own money.
Like I said before, we are all emotional beings and anything that helps reduce the emotional ties to your money will also help you make better investment decisions.
AJ Monte is a Chartered Market Technician and member of the Market Technicians Association (MTA). He, along with his two partners Rick Swope and Bill Shanley, are known as “The Market Guys”. With over 26 years of experience trading the markets AJ served two years as Chairman of the Options Floor Trading Committee for COMEX, and hosted a financial program on PBS called Wealth & Wisdom. You can tune into their Radio Show, broadcasted worldwide, through On Demand radio with The Market Guys. This weekly program can be accessed by visiting www.themarketguys.com.