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Tips on How to Trade Like a Champion

June 15, 2015



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 ONLY AS LONG 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 someonebuys 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.

 

 

Excerpts from TRADE LIKE A STOCK MARKET WIZARD; HOW TO ACHIEVE SUPERPERFORMANCE IN STOCKS IN ANY MARKET



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