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The Deipnosophist

Where the science of investing becomes an art of living

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Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

25 August 2005

Dealing with the inevitable losses

I follow Price's comments, when appropriate, with my own [found within brackets and italicized]...

Handling Losses
Price Headley

Most traders typically like to talk about their winners while avoiding any recollection of their losers. Smart traders will be aware of the patterns that occur with losing trades, so as not to hold losing trades any longer than necessary.

If you have been an investor for any length of time, you will have experienced a loss. While experiencing a loss is less than enjoyable, the real danger of a losing trade is the threat it poses to your confidence and your mental approach. That said, here are some ground rules to keep in mind:
1. Understand the difference between confidence and unreasonable expectations. You should believe that every trade you place, based on your systematic criteria, is going to be a winner. If you are not confident of that, then don't place the trade. However, realize that over a given length of time, at least some of your trades will work against you. Even a great trading system fails sometimes, so your job is to make sure your system has an overall net positive return. If you are redefining your trading system for every trade in an effort to insure success, that is simply a signal that the system is ineffective. [I dislike the use of the word, "system" (I prefer "method" or better yet, "plan"), but concede Price's argument. In particular, his final sentence.]

2. Cut losses. It is critical that you be willing to take small losses before they turn into big losses. I can't tell you the number of times I've heard someone say about a stock "I'm sure it will come back.", only to see the share price continue to deteriorate. Besides doing damage to your account value, riding a loss can be a substantial blow to your confidence. If you are that confident about a stock, then sell it at a small loss and buy it back when you see it begin to turn around. [This is one method; there are others. Most traders, however, have no method, no plan.]

3. Don't try trade your way out of a loss. (This is an extension of rule number one.). By this I mean don't follow up a loss by placing a trade you wouldn't have normally placed in an effort to make up for the loss. The past can't be changed, so let go of it and approach the next trade in an unbiased manner.

4. Constantly learn. I'm not going to say there is something to be learned with every loss, because sometimes there is not. When there is something to learn though, then you certainly should learn it. More importantly, if what you learn is something that will improve your trading system, take it and apply it to your system. (Notice here that I said to apply it to your system, not just to your next trade.) Your system must have an overall net positive result, but there is nothing wrong with constantly improving your system.

5. Don't let losses paralyze you. It's just part of investing. While a loss may give us reason for caution, take a step back and look at your overall goals and your overall trading approach. If your confidence is injured, then paper trade for a while until you can see that your system has merit and you can invest successfully. It's imperative that you don't simply avoid investing. [Investors invest and traders trade. One critical difference between the two is time. Have time work for you rather than against you. There is a difference between using time to your advantage (timing) -- and doing nothing. Of course, it is altogether a different matter if you have no investing methodology (read, plan) in place.]

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