No investment approach is worth a look if it doesn’t address market risk. The business of investing in the stock market is one of the most humbling of all. After all, in how many businesses can you be correct nine times out of ten and still lose money? You can when investing in the stock market if that one loss swells to the point that it engulfs your gains. And that’s exactly what can happen if you allow market losses to deepen and go unchecked. Not addressing your losses by ignoring them or making excuses is like refusing to treat a cut. It can become a hemorrhage—or worse. You’d never allow that situation to occur health-wise, so why would you risk it happening in a monetary sense? But it does occur time and time again. Let me say it here and now in no uncertain terms: if you’re not willing to take losses and admit mistakes, then the business of investing or trading in the stock market isn’t for you.
How you deal with your market losses is a defining characteristic in attempting to achieve investment success. Make no mistake about it: you will be faced with stressful, money-losing situations on many occasions in your investing career, just as life often throws you a curve ball. It happens. Things don’t always flow smoothly in either sphere. You need to have a plan to deal with these occurrences. If I’m holding a stock position at a loss, here’s what I do:
- Halt further purchases.
I usually have a set price range in which I’ll accumulate shares. But once that range is violated I take a step back and, in keeping with our relationship theme, assess the situation. I check to see if there’s been any significant damage to the stock’s chart pattern. If it’s basically intact I’ll retain the position, but wait until the shares start to perform better on a supply-demand basis before resuming my purchases. However, if I see some technically troubling signs from analyzing my price graphs, my share sales will be in proportion to the extent of the damage I determine. For instance, I’d be a more aggressive seller of shares if my technical research revealed longer-term deterioration as opposed to a shorter-term supply-demand difficulty. On the buy side, I rarely purchase my full equity position at once, preferring instead to do so on several occasions over a period of time based on risk/reward considerations. - Question my thinking, not the market’s.
When a position goes against me, I don’t blame the market. I don’t assume that it’s wrong. It’s my error, my fault, my “bad.” As I’ve said before, the stock market is both judge and jury, and its verdict—the price quote—is final. All the excuses and reasoning in the world won’t change that. The stock market is the beach; I’m only a grain of sand on it, if that. I accept its verdict and proceed from there. Reality, in stock market terms, is the price of your shares. Period. - Don’t penalize the winners.
I know there’s a temptation to consider selling one or more stock market winners to pay for a losing name. I’ve been in that situation myself. The desire to take a gain will outweigh the desire to take a loss in the majority of cases. After all, taking credit for a market winner is far easier than accepting blame for a losing trade. It’s like that in life: discussing our successes is enjoyable; far less so our failures. But that’s not a sensible investment game plan. Why penalize a name for acting better than the shares in which you’re experiencing a loss? It’s like deciding to break up with someone who enhances your life’s “portfolio” in order to date someone with whom you have little in common or don’t get along with. It doesn’t make sense. In the stock market as in life, you’re better off removing yourself from a negative force than removing yourself from a situation that’s going satisfactorily. - Dwell on it.
You might argue that dwelling on your losing trades is like regularly remembering your car accident, a bad real estate deal, or that difficult breakup with your boyfriend or girlfriend you experienced years ago. Why do that? Because you want to learn from the experience and try not to repeat the error. You want to examine where you think you went wrong. Hey, it’s a piece of cake to remember your market winners and the good times, but do we really learn from them? Isn’t an ongoing purpose of life to note our errors and correct them in order to become better individuals? Learning from your market miscues can aid you in becoming a better investor as well. Face them. - Look at a worst-case scenario.
I don’t mean to sound depressing. Actually, yes, I do in this particular case. While worst-case scenarios usually don’t materialize, you need to plan for them since there’s no way of knowing which situations can turn out that way. Isn’t that why we have insurance, extended warranties, generators, home alarms, and the like—just in case? Doing so also makes for a humbling demeanor, investment-wise. It keeps you in market reality. In chapter 7, “Financial Freud,” one of the questions I suggest you ask yourself is, “Do I have more than enough money in reserve in case something totally unexpected occurs?” Make sure that a sudden slide in one or more of your holdings or the market in general won’t take you back a giant financial step, and review your overall financial situation to see if you’re overextended in your investments relative to your monetary responsibilities outside of the stock market. Remember, unexpected things happen. Don’t think that they won’t. And don’t ever be complacent.
A well-thought-out risk management plan is a crucial element of any investment strategy. Losses are a part of that plan. Taking a loss is an art; how you fare in that area is perhaps the most important determinant of your long-term investment success. After all, you can’t invest capital in a bull market if you haven’t properly preserved it during the prior bear market phase. Depending on their investment styles and strategies, stock market participants will have varying risk tolerances before they admit defeat (accept a loss). Shorter-term traders are going to have different parameters for buying and selling stocks than long-term investors will. No matter which approach you choose, and there are several, the key is to be able to manage the downside portion of the investment equation. While I’m not a short-term trader, if a position I’ve purchased suddenly goes against me and violates what I believe to be price levels of import, I’ll sell the shares. No excuses.
In the stock market, as in life, concentrating on your mistakes and faults isn’t appealing, but it’s mandatory if you are going to have a shot at correcting them. Just as one needs to be alert to see flaws in an individual that could hurt a relationship and gauge if its seriousness dictates an end to that bond, investment vigilance and regular review is warranted in deciding when to part with all or part of an equity position.
The approach I preached to the brokers at the large wire houses in which I was privileged to serve grew out of my own personal trading experiences and market observations. I called it TARMA—the Technical Analysis Risk Management Approach to investing—its cornerstone being that capital preservation should always precede capital appreciation. I never give a speech without referring to it in some fashion.
Risk must be managed in both life and the stock market. Maybe that’s why, with regard to the former, I’ve only owned Volvo automobiles—because I see the road as one big danger zone. Contrary to what you hear about a car being a bad investment because it loses value so rapidly upon leaving the dealer’s lot, I view the scenario much differently. A car with a top-notch crash test and advanced safety features ranks as a great investment in my book, especially for the kids! It’s far more important than capital preservation; it’s potentially life preserving. You’re in your car a lot, which means that you’re exposed to risk often, which means that you have to address that potential risk by owning a safe vehicle. I also have air purifiers in my house (eight, plus two commercial-grade ones for construction projects), earthquake insurance (yes, in New Jersey), and regularly trim the tree branches near my home. I’m always assessing risk. While you may think I’m going overboard in this area, I believe it has helped me, as well as those I have served, over my stock market career. All right, so it stresses my patient wife at times and rightly so. Still, my investment motto is “more worry rather than less” because I’ve seen the catastrophic financial toll a big bear market can inflict. To me, planning for the unexpected always makes sense.
Moral: Risk management should occupy a central role in your stock market investments just as it does in your personal life. It involves planning for the unexpected and addressing difficulties head-on. Strongly consider using the investment tenets mentioned in this book as a component for your risk management investment plan. Read the accounts of experienced money managers and traders who have successfully implemented strategies to address market risk and preserve capital during bear markets, as well as the financial consequences experienced by those who didn’t. And don’t forget to read Reminiscences of a Stock Operator, a timeless stock market classic written in 1923.
(To be continued...)
This excerpt is taken from “Relationship Investing: Stock Market Therapy for Your Money” by Jeffrey S. Weiss. To read other articles of this book, click here. To buy this book, click here.
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