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How to Trade Like a Stock Market Wizard

Excerpts from the best-selling book Trade Like A Stock Market Wizard: How to Achieve Superperformance in Stocks in Any Market

January 24, 2016



 

Introduction

 

Investing styles may differ among successful market players, but without exception, winning stock traders share certain key traits required for success. Fall short in those qualities and you will surely part ways with your money. The good news is that you don’t have to be born with them. Along with learning effective trading tactics, you can develop the mindset and emotional discipline needed to win big in the stock market. Two things are required: a desire to succeed and a winning strategy.

 

I’ve been trading and investing in the stock market for most of my adult life: 31 years and counting. Stock trading is how I made my living and ultimately my fortune. Starting with only a few thousand dollars, I was able to parlay my winnings to become a multimillionaire by age 34. Even if I had not become rich from trading stocks, I would still be doing it today. For me, trading isn’t a sport or just a way to make money; trading is my life.

 

I didn’t start out successful. In the beginning, I made the same mistakes every new investor makes. However, through years of study and practice, I gradually acquired the necessary know-how to achieve the type of performance you generally only read about. I’m talking about superperformance.

 

There’s a big difference between making a decent return in the stock market and achieving superperformance, and that difference can be life-changing. Whether you’re an accountant, a schoolteacher, a doctor, a lawyer, a plumber, or even broke and unemployed as I was when I started, believe me you can attain superperformance.

 

 

Consistency Wins the Race

 

People buy stocks in hopes of making money and increasing their wealth. They dream of the great returns that their carefully chosen investments will yield in the future. Before investing your hard-earned cash, however, you’d better think about how you will avoid losing it.

 

If there’s one thing I’ve learned over the years, it’s that risk management is the most important building block for achieving consistent success in the stock market. Notice that I said “consistent.” Anyone can have short-term success by being in the right place at the right time, but consistency is what differentiates the pros from the amateurs, the timeless legends from the one-hit wonders.

 

I once bowled a 259 during my very first year playing in a Wednesday night league. It was a bizarre aberration. My average was only 129, and I would never break 200 again. During my career, I’ve witnessed many people make millions of dollars during good times, only to give it all back and even go broke. I’m going to tell you how to avoid that fate.

 

 

It’s Your Money, but only as Long as You Protect It

 

To achieve consistent profitability, you must protect your profits and principal. As a matter of fact, I don’t differentiate between the two. A big mistake I see many traders make is to consider trading profits as house money, acting as if that money somehow were less their own to lose than their original starting capital is. If you have fallen into this mental habit, you need to change your perception immediately to achieve superperformance.

 

Let’s say I make $5,000 on Monday. I don’t consider myself $5,000 “ahead of the game,” free to risk that amount shooting for the moon. My account simply has a new starting balance, subject to the same set of rules as before. Once I make a profit, that money belongs to me. Yesterday’s profit is part of today’s principal.

 

Don’t fall into the faulty reasoning of amateur gamblers. Through consistent play and conservative wagering, a player picks up $1,500 at the blackjack table. Then he starts to make big, reckless bets. In his eyes, he now is playing with house money. This happens all the time in the stock market. Amateur investors treat their gains like the market’s money instead of their money, and in due time the market takes it back.

 

Let’s say someone buys a stock at $20 a share. It climbs to $27. Then the investor decides he can “give it room” because he has a seven-point cushion. Wrong! Once a stock moves up a decent amount from my purchase price, I usually give it less room on the downside. I go into a profit-protection mode. At the very least, I protect my breakeven point. I’m certainly not going to let a good gain turn into a loss.

 

At the end of each trading session, when you review your portfolio, ask yourself this: Am I bullish on this position today? If not, why am I holding it? Does your original reason for going long remain valid? End every trading day with a frank appraisal of all your positions. I’m not suggesting that you not allow a stock to go through a normal reaction or pullback in price if you believe the stock can go much higher.

 

Of course, you should give stocks some room to fluctuate, but that leeway has little to do with your past gain. Evaluate your stocks on the basis of the return you expect from them in the future versus what you’re risking. Each day, a stock must justify your confidence in holding it for a greater profit.

 

 

Avoid the Big Errors

 

Recently I had a chance to speak with Itzhak Ben-David, coauthor of the study Are Investors Really Reluctant to Realize Their Losses? Trading Responses to Past Returns and the Disposition Effect. The tendency to sell winners too soon and to keep losers too long has been called the disposition effect by economists.

 

Mr. Ben-David and David Hirshleifer studied stock transactions from more than 77,000 accounts at a large discount broker from 1990 through 1996 and did a variety of analyses that had never been done before. They examined when investors bought individual stocks, when they sold them, and how much they earned or lost with each sale.

 

They also examined when investors were more likely to buy additional shares of a stock they had previously purchased. Their results were published in the August 2012 issue of the Review of Financial Studies.

 

The study highlights several interesting conclusions:

 

• Investors are more likely to allow a stock to reach a large loss than they are to allow a stock to attain a large gain; they hold losers too long and sell winners too quickly.

• The probability of buying additional shares is greater for shares that have lost value than it is for shares that have gained value; investors may readily double down on their bets when stocks decline in value.

• Investors are more likely to take a small gain than a small loss.

 

Most investors are simply too slow in closing out losing positions. As a result, they hold on until they can’t take the pain anymore, and that eats up precious capital and valuable time. To be successful, you must keep in mind that the only way you can continue to operate is to protect your account from a major setback or, worse, devastation.

 

Avoiding large losses is the single most important factor for winning big as a speculator. You can’t control how much a stock rises, but in most cases, whether you take a small loss or a big loss is entirely your choice. There is one thing I can guarantee: if you can’t learn to accept small losses, sooner or later you will take big losses. It’s inevitable.

 

To master the craft of speculation, you must face your destructive capacity; once you understand and acknowledge this capacity, you can control your destiny and achieve consistency. You should focus a significant amount of time and effort on learning how to lose the smallest amount possible when you’re wrong. You must learn to avoid the big errors.

 

 

Practice Does Not Make Perfect

 

I know people who have managed money on Wall Street for decades yet have only mediocre results to show for it. You would think that after all those years of practice their performance would be stellar or at least would improve over time. Not necessarily. Practice does not make perfect. In fact, practice can make performance worse if you are practicing the wrong things.

 

When you repeat something over and over, your brain strengthens the neural pathways that reinforce the action. The problem is that these pathways will be reinforced for incorrect actions as well as correct actions. Any pattern of action repeated continuously will eventually become habit. Therefore, practice does not make perfect; practice only makes habitual.

 

In other words, the fact that you’ve been doing something for a while doesn’t mean you are guaranteed success. It could be that you’re just reinforcing bad habits. I subscribe to the advice of the legendary football coach Vince Lombardi. As he said, “Practice does not make perfect. Only perfect practice makes perfect.

 

In the stock market, practicing wrong will bring you the occasional success even if you’re using flawed principles. After all, you could throw darts at a list of stocks and hit a winner once in a while, but you will not generate consistent returns and eventually you will lose.

 

The reason most investors practice incorrectly is that they refuse to objectively analyze their results to discover where their approach is going wrong. They try to forget the losses and keep doing what they’ve always done. The proliferation of cheap brokerage commissions, Internet trading, and web-based stock market data may have provided everyone with the same technology, but it did not grant investors an equal ability to use those resources.

 

Just as picking up a five-iron doesn’t make you Tiger Woods, opening a brokerage account and sitting in front of a computer screen doesn’t make you Peter Lynch or Warren Buffett. That’s something you must work for, and it takes time and practice. What’s important is that you learn how to practice correctly.

 

 

Avoid Paper Trading

 

Do the thing and you will have the power.  —Ralph Waldo Emerson

 

As new investors learn the ropes, often they engage in paper trading to practice before putting real money at risk. Although this sounds reasonable, I am not a fan of paper trading, and I don’t recommend doing it any longer than absolutely necessary until you have some money to invest. To me, paper trading is the wrong type of practice. It’s like preparing for a professional boxing match by only shadowboxing; you won’t know what it’s like to get hit until you enter the ring with a real opponent.

 

Paper trading does little to prepare you for when you are trading for real and the market delivers a real punch. Because you are not used to feeling the emotional as well as the financial pressure, it will be unlikely that you will make the same decisions you did in your practice sessions.

 

Although paper trading may help you learn your way around the market, it can also create a false sense of security and impede your performance and learning process. The psychologist Henry L. Roediger III, who is the principal investigator for the department of psychology at Washington University in St. Louis, conducted an experiment in which students were divided into two groups to study a natural history text. Group A studied the text for four sessions.

 

Group B studied only once but was tested on the subject three times. A week later the two groups were tested, and group B scored 50 percent higher than group A. This demonstrates the power of actually doing the thing you’re trying to accomplish versus preparing for it in simulation.

 

If you’re just starting out, you should trade with real money as soon as possible. If you’re a novice trader, a good way to gain experience is to trade with an amount of money that is small enough to lose without changing your life but large enough that losses are at least somewhat painful. Don’t fool yourself into a false sense of reality. Get accustomed to trading for real because that’s what you’re going to have to do to make real money.

 

 

Commit to an Approach

 

You don’t need a PhD in math or physics to be successful in the stock market,just the right knowledge, a good work ethic, and discipline. My SEPA® methodology was developed after decades of searching, testing, and going back to the drawing board countless times to uncover what actually works.

 

You, too, will go through your own trial-and-error period: window-shopping and trying various concepts and approaches to the stock market, whether value, growth, fundamental, technical, or some combination.

 

In the end, to succeed, you will need to settle on an approach that makes sense to you. Most important, you must commit to perfecting and refining your understanding of that methodology and its execution.

 

A stock trading strategy is like a marriage; if you’re not faithful, you probably won’t have a good outcome. It takes time and dedication, but your objective should be to become a specialist in your approach to the market.

 

Although strategy is important, it’s not as critical as knowledge and the discipline to apply and adhere to your rules. A trader who really knows the strengths and weaknesses of his or her strategy can do significantly better than someone who knows only a little about a superior strategy. Of course, the ideal situation would be to know a lot about a great strategy. That should be your ultimate goal.

 

 

Invest in Yourself First

 

When I began trading in the early 1980s, I endured a six-year period whenI didn’t make any money in stocks. In fact, I had a net loss. It wasn’t until 1989 that I began to achieve meaningful success. What kept me going?  Unconditional persistence! An investment in knowledge, which takes time to acquire, is an investment in yourself, but it requires persistence.

 

When you make an unshakable commitmentto a way of life, you put yourself way ahead of most others in the race for success. Why? Because most people have a natural tendency to overestimate what they can achieve in the short run and underestimate what they canaccomplish over the long haul. They think they’ve made a commitment, but when they run into difficulty, they lose steam or quit.

 

Most people get interested in trading but few make a real commitment. The difference between interest and commitment is the will not to give up. When you truly commit to something, you have no alternative but success. Getting interested will get you started, but commitment gets you to the finish line.

 

The first and best investment you can make is an investment in yourself, a commitment to do what it takes and to persist. Persistence is more important than knowledge. You must persevere if you wish to succeed in anything. Knowledge and skill can be acquired through study and practice, but nothing great comes to those who quit.

 

 

Expect Some Rotten Days

 

Many of life’s failures are people who did not realize how close they were to success when they gave up. —Thomas Edison

 

The key to success is to become a successful thinker and then act on those thoughts. That doesn’t mean that all your ideas and actions will always produce the desired results. At times you will feel that success is unattainable. You may even feel like giving up. I know. I’ve been there.

 

As I said, I went six consecutive years without making a penny while pursuing stock trading. Along the way I had days when I felt so demoralized by my unsatisfactory results that I almost threw in the towel and gave up.

 

However, I knew the power of persistence. Then, after more than a decade of trial and error, I was making more money in a single week than I dreamed of making in a year. I experienced what the English poet and playwright Robert Browning meant when he wrote, “A minute’s success pays the failure of years.”

 

Remember, if you choose not to take risks, to play it safe, you will never know what it feels like to accomplish your dreams. Go boldly after what you want and expect some setbacks, some disappointments, and some rotten days. Embrace them all as a valuable part of the process and learn to say, “Thank you teacher.”

 

Be happy, feel appreciative, and celebrate when you win. Don’t look back with regrets at failures. The past cannot be changed, only learned from. Most important, never let rotten days make you give up.

 

 

Conclusion

 

To realize profits from investing in stocks, you must make three correct decisions: what to buy, when to buy, and when to sell. Not all of your decisions will turn out to be correct, but they can be intelligent.

 

It is true that the market is brutal to most of the people who challenge it. But so is Mount Everest, and that shouldn’t—and doesn’t—stop people from trying to reach the top. What is expected of a mountain or a market is only that it have no favorites—that it treat all challengers as equals.

 

Trading can be an intellectual stimulation, as well as a way to make money. Played well, it demands skills of the highest order, and skills the trader must work very hard to acquire. A well-conceived and executed transaction is a thing of beauty, to be experienced, enjoyed, and remembered. It should have an essence transcending monetary reward.

 

The stock market provides the greatest opportunity on earth for financial reward. It also teaches great lessons to those who win and those who lose, an education that goes well beyond trading and investing. Without a doubt, the stock market gives you incredible exhilaration when you win and deep humility when you lose. It is the greatest game on earth.

 

 

Excerpts taken from TRADE LIKE A STOCK MARKET WIZARD: HOW TO ACHIEVE SUPERPERFORMANCE IN STOCKS IN ANY MARKET. Copyright 2013 Mark Minervini – published by McGraw Hill.  



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