How To Keep One Bad Trade From Destroying Your Account
Whenever I’m entrenched in something, I tend to analyze every single possible outcome before making a move. My wife thinks I’m weird for this, but I don’t mind… It helps me understand the world – and more often than not, it leads to a rational decision-making process that works out pretty well.
Take driving a car for example. I don’t see the point in speeding. Of course, sometimes I don’t realize how fast I’m going, or perhaps I missed the speed limit sign. But for the most part, I don’t speed. The risks outweigh the reward.
Most folks speed if they’re running late, thinking they will make up lost time. And sure, they’ll make up a minute or two depending on the distance they’re traveling, but is that extra minute you might make up worth getting a speeding ticket? Because if you get pulled over, not only will you be extra late as the cop mulls over your license and registration. But if he gives you a speeding ticket now you are out time and money.
It’s that simple. The risks of speeding outweigh the reward. So, I do my best to stay within the speed limit.
This kind of thinking comes in handy especially when it comes to stocks.
In fact, I’ve spent the past decade thinking about the risks associated with stocks. Specifically, I now analyze most decisions (to buy or sell) comparing the downside to the relative upside. In other words, risk versus reward.
The Risks Associated With Winning
Everybody assesses risk differently, whether we’re talking about speeding or the stock market.
Unfortunately, when it comes to the stock market, many investors assess their risk as if they must do 80 mph in a 55-mph zone in order to be successful.
But that couldn’t be further from the truth.
My longtime readers know that I talk more about risk management – that is, avoiding losses – than I do about finding that next big winner. That’s because if you take too big of a loss, you won’t have enough capital to put towards that next big winner.
Fortunately for us, we have rules and sell signals in place to curb our risk and keep our losses small. And I’ve talked about why it’s so vital to cut losses short a number of times. So today I want to talk about another risk that can easily creep up on us, especially during periods of resounding returns like we witnessed in 2019.
When we have a year like 2019, where the S&P 500 returned roughly 30% and nearly everything we touched made money, we become overconfident. That confidence urges us to inch up our allocation with every trade.
Perhaps you were only allotting 2% of your portfolio to each trade. But because of the success, that 2% inches up to 3%, then 4% or 5%. Pretty soon we are putting all our eggs in one basket, believing that our winning streak will continue.
Action To Take
Take it from me. I’ve been a victim of this line of thinking. And I assure you, the market will quickly humble you.
This happened to me when I was trading currencies. I nailed a handful of trades and grew my account nearly 20% in less than a month. I was risking very little with each trade and stuck to my game plan. But because of the success I had, I decided to put more money at stake.
I did okay with my next couple of trades, then upped my allocation a little more.
Because of my increased exposure, my next trade wiped out all my profits and then some. Had I stuck to my normal allocation, I would still be up double digits after that loss. Instead, after racking up numerous winners, I was down a few percent overall – all because of one bad trade.
So again, take it from me. Don’t let the winning go to your head. You will inevitably make a losing trade once in a while. Keep your allocations in check. With each trade, just assume going into it that you are going to lose money. If you can’t stomach that, then you need to lower your allocation.
Remember, it’s not how much money you make, it’s how much you keep. Don’t let one trade blow up your account.
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