The Golden Rule: Preserve Your Capital
Whole books can (and have) been written on the topic of money management as it relates to investing, but at the end of the day, it comes down to one thing. Preservation of your capital.
This goes back to the old saying that “it takes money to make money.” If you lose your investment capital, you’re out of the game. If you’re out of the game, you can’t make profitable trades.
Take a look at the chart below. If you lose a portion of your investing capital, then your remaining capital has to work harder (earn higher returns) just to get back to where you were. The more you lose, the harder your remaining funds have to work. The lesson here is simple: Avoid losses at all costs. This is the reason why it’s so important that your investment strategy include a rules-based system for cutting your losses as quickly as possible when a trade goes south on you.
((insert charts like the ones found on MM_C_004))
As you can see based on the chart, small losses are relatively easy to recover from, but as losses mount, eating up an increasing percentage of the capital you’re working with, it becomes increasingly harder to recover. Notice that a loss of 50% of your capital will require your remaining stock to see a 100% gain just to break even.
Novice investors will wrongly conclude that the way to avoid losses is to further hone their analytic skills in order to make fewer trading mistakes. Again though, if analytics alone made a successful trader, then computer-driven, rules-and-analytics-based trading would be successful virtually 100% of the time. It’s not. No, as counterintuitive as it may seem, the only way to limit your losses is to take them and take them early.
If that statement leaves you scratching your head in puzzlement, just understand that it’s based on a real-world analysis of thousands of trades conducted by hundreds of different traders.
Most of the times, a trade will either result in a small profit or a small loss. Very occasionally though, a trader will make an investment that sees a big payoff. Also, very occasionally, a trader will make a trade that results in a catastrophic loss, and as you’ve seen on the charts, it’s those catastrophic losses that are the kiss of death.
The secret then, is to make sure all your losses (and you’ll have plenty of them) are small, and thus easily recovered from, while allowing your winning trades to run as long as they will, in order to maximize your profits.
Here’s the thing though: We (meaning people in general) don’t like to lose. It’s a blow to our ego and self-esteem. Taking a loss…even a small loss is something most people see as an affront, and for that reason, they’re reluctant to do it.
In other words, many traders ultimately fail because they allow their egos to get in the way. This is the reason that psychological factors play an important role in the design of your trading strategy, and why we’ll be talking more about them later on in this course.
Note too that you can go too far the other way. It’s one thing to cut your losses short, but many novice trades also develop the bad habit of cutting their profits short too. This is incredibly unwise.
You might be asking yourself, “how can you lose if you’re making money?” If you mentally asked a question like that, you’re not alone. In fact, there’s a saying, popular among novice investors: “You can never go broke taking a profit!”
Sadly, this is far from true, even though that too, sounds counterintuitive.
It’s important to remember that trades don’t happen in isolation. As an investor, you’re going to be making tons of trades, week after week, month after month, and year after year.
Your goal is to balance your small gains and losses, let your big gains run as long as possible, and eliminate catastrophic losses from the equation altogether. If you consistently cut your profits short, then you’re guaranteeing that you’re only going to ever see mediocre gains, which means you’ll have relatively fewer profits to offset your inevitable losses with. Not good.
Ultimately, what happens to traders who adopt this view is that they inevitably find themselves in a position where, because they insisted on cutting profits short and only allowing themselves modest gains, they’ll wind up losing money on their trades as a whole. Those modest gains aren’t enough to offset the inevitable losses and earn you a profit, as tempting as it might be to imagine they would be.
These things taken together underscore….