There are two things that will help you become a better investor, and could help you manage your way through the next market meltdown...
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The two concepts I'm going to talk about today are easy to grasp. But what makes them difficult to execute is our emotions...
You may have heard people say, "I hate losing more than I like winning." While this sentiment often pertains to sports or some other event of a competitive nature, it's precisely the sort of thinking that often causes investors to lose their shirt.Of course, nobody likes to lose, especially when it comes to money. But that fear of loss overcomes our rational self and greatly decreases the probability of success. You see it happen in the sports world all the time. A team is up big and it begins playing "not to lose." Instead of continuing to do what got them into the winning position in the first place, they seize up. The fear of losing the lead -- and the game -- overcomes them. Sometimes they squeak by with a narrow win, other times they give up the lead entirely.
In investing, it's a human tendency to behave irrationally when it comes to taking profits and losses. According to Economics Nobel Prize winner Daniel Kahneman, this is known as "prospect theory."
One of the hardest things to do is keep your emotions from clouding your judgment. Once you allow emotions to get the better of you, you lose your confidence, self-doubt creeps in and you begin second-guessing yourself with every investment or move you make. Emotions make you question everything you're doing in the markets... especially during turbulent market environments.
That's why today I want to talk about a couple of things you can do that should help put your mind at ease -- and help prepare you -- when the next bout of volatility hits.
Nobody likes to be wrong. And taking a loss is proving exactly that... that you were wrong.
It's been proven that investors tend to sell their winners too early, satisfying their desire to be right, and hold on to their losers too long, hoping that they will not have to take a loss and be wrong.
The simple fact is that we as investors will be wrong. It happens to the best of us. And chances are good that we'll be wrong quite often. But as prominent investing magnate George Soros once said, "It's not about being right or wrong, rather, it's about how much money you make when you're right and how much you don't lose when you're wrong."
I've told this story before, but it's worth repeating, as it gives a perfect example of why you need risk management...
Joe Campbell thought he found the perfect trade, one that was sure to make him rich.
A drug development company by the name of KaloBios Pharmaceuticals announced it would wind down its operations and restructure in order to liquidate its assets. In short, the company was going out of business.
So Campbell shorted $18,000 worth of the stock. After all, the company was going out of business. What could go wrong?
An investor group came in and acquired 50% of outstanding shares and announced it would form a plan to allow the company to continue operations.
Overnight, shares of the stock shot up more than 650%...
When the trader checked his account, not only did he lose his entire balance of $37,000, but his account balance actually showed a negative balance of $106,445.56.
Instead of striking it rich, he owed his brokerage six figures.
I bring this story up to point out one of the many mistakes this investor made... he risked almost 50% of his capital on one trade. This is not prudent investing, that's gambling.
One of the simplest and most effective ways to protect your capital is through risk management. Establish strict sell or loss parameters and follow them.
One popular risk management method is the 2% rule, which means you never put more than 2% of your account equity at risk in any single trade.
For example, if you are trading a $50,000 account and you choose to use the 2% rule, that means you are willing to risk $1,000 on any given trade. The great thing about this rule is that if you stick to it, you would have to make dozens of consecutive 2% losing trades in order to literally go broke. And even for a novice investor, this is highly unlikely to happen.
Keep in mind that the 2% number is arbitrary; you can adjust it to fit your level of risk tolerance. But it provides investors with a foundation on which to make trading decisions.
For instance, say you wanted to buy shares of Apple (Nasdaq: AAPL) and you only wanted to risk $1,000, or 2% of a $50,000 portfolio. You set your exit or stop-loss at 20% (another arbitrary number that can be adjusted based on your risk tolerance). You can now figure out how large of a position, or how many shares you will buy.
To find this number you first divide 100 by your stop loss, in this case 20, which results in five. Then you take that number -- five -- and multiply it by the amount you want to risk, $1,000.
Five times $1,000 is $5,000, which means you can buy $5,000 worth of Apple stock... or 27 shares if the stock is trading at $184 per share.
If Apple declines 20%, you'll lose about $1,000 and exit the position.
But let's say that you want to use a smaller stop-loss, like 13%, on your Apple position. Here's how the math works...
-- 100 divided by 13 equals 7.7.
-- 7.7 times $1,000 equals $7,700.
-- $7,700 divided by the share price, $184, equals 42 shares.
Determining the proper position size before placing a trade will not only dramatically impact your trading results, but it will help put your mind at ease.
If you can master the art of understanding losses and position sizing -- you will be leaps and bounds ahead of other investors. To be sure, these are guidelines that can be, and should be used investors of all shapes and sizes. Plus, having a plan in place will help you sleep better at night during market drawdowns, knowing that you aren't taking extraordinary risks with your capital.
Followers of the MP Score system understand exactly how this works. For us, it means using the system's two proven indicators (one technical, one fundamental) to arrive at an MP Score, which tells us exactly when to buy and when to sell.
It's that simple. By having a plan and relying on a proven system, take emotion out of the equation and have an entry/exit plan right off the bat. Because of this, we've been able to notch gains of 20% in 14 days... 82% in 48 days... 118% in 86 days… and 266% in 12 months. If you'd like to learn more about the MP Score, I invite you to follow this link.
This article originally appeared on StreetAuthority.com.