A dangerous misconception many DIY Investors have is that our job day-to-day is to “make money”. Obviously, that is the outcome we are hoping to achieve, but it is not what we actually do. Remember, we have no control over the direction of the market or of our holdings at any point in time.
No, our primary job is to manage risk. Day in, day out this is what we are actually doing. The stock market can provide life changing monetary rewards, but with those rewards come enormous risks. The only way to safely gain exposure to the rewards of trading is to strictly define and manage the risk you are taking.
There are two primary ways we do this:
Our position sizing tool combines these concepts. I encourage you to play around with it so you can get a good handle on how much you are risking on any given trade.
There is, however, another often overlooked component of risk management that is perhaps even MORE important than the ones above: patience.
By this I mean having the discipline to allow marginal or higher risk trade ideas go without you while patiently waiting for the BEST, low risk, high probability setups.
Warren Buffett has a famous quote that’s relevant: “The stock market is a no-called-strike game. You don’t have to swing at everything — you can wait for your pitch.”
The fact is, every time we enter a trade we are putting our money at risk. Therefore, we should always take a moment beforehand to ask ourselves, “is the perceived reward worth the risk?” Be picky. Be patient. I promise you, it will pay off.
This concept comes to mind when looking at a chart of the S&P 500. The market has just run 15% higher in about two months. It’s just below a declining trend line that connects the closing highs from last July and November.
If the current rate of ascent continues, we could be looking at new all-time highs in just a few weeks! However, what is most likely to happen? Personally, I think that after such a big run and at an important trend line, it’s more likely that the market will pull back in this area. This doesn’t necessarily mean that we should get short. The market doesn’t HAVE to pull back. And if it does, keep in mind that it would actually be bullish for the market to put in a definitive higher low before breaking the macro pattern of lower highs and lower lows.
The bottom line is we have a short term bullish market still within a larger bearish look. These mixed messages are about to come to a head so I believe the best course of action right now is patience. It makes no sense to increase exposure to risk in the face of this uncertainty by taking big bets here. Let’s continue to manage our open positions and patiently observe market action in this pivotal area. There will be plenty of time to pounce when the outlook becomes clearer.
Some things are within our control. This category is the internal realm which includes our actions, perceptions and attitudes.
Then there is everything else; things we only have limited influence over at best. This is the world external to us which includes the actions of others and nature for example.
Stoic philosophy contends that confusing these categories is the primary source of our unhappiness. How many people fret over things which they cannot control, resulting in unnecessary stress and frustration? There is no reason to allow external events to hold our happiness hostage. We hold the power to avoid this self-imposed trap by simply changing our attitude and focus.
Again, obsessing or stressing about things outside of our control is counterproductive.
Instead, we should focus our effort and energy on those things we actually do control.
I make it a point to live by these principles. Not because I’m such a great guy, but because I’m allergic to stress. Seriously, I detest stress. Stress ages you. Stress makes you fat. Stress weakens the immune system. Stress just plain sucks.
Also, I don’t want to pointlessly spin my wheels. Life’s too short. I only want to invest my limited time and energy on action that counts.
One example of how this principle looks applied is process vs. outcome. We control the processes we develop and follow. However, we do NOT control the outcome of those processes.
Let me give you a real life example. When we were trying to sell our house in San Antonio, it took much longer than expected or hoped. As the summer started to draw to a close, I could feel the stress level my wife and I experienced start to elevate. After every showing, we were consumed with self-doubt, second guessing ourselves with questions: “Are they going to make an offer?” “Why aren’t they calling?” “What’s wrong with this house?” etc.
Eventually I started to remind my wife (and myself) that we don’t control the whether the person viewing the house will buy it or not (outcome) so there is no point in worrying about that. Let’s just focus on cleaning the house and making it appear inviting before each showing (process) and be content with doing our best.
If we focus on improving and following our process, the outcome will generally take care of itself.
Of course, we eventually did sell that house and importantly, we did it while also saving ourselves a lot of unnecessary stress when we changed our focus and mindset.
This principle can be helpful in many areas of our lives, such as if we are trying to lose weight or learn a new skill.
It also happens to be especially useful when trading.
We have absolutely no control whether a stock goes up or down. The only thing we control is when we buy and when we sell.
It’s critical to remember this, especially when we inevitably hit a string of losing trades. It’s easy to lose our confidence which can paralyze us from taking further action. Worse, we may lose our discipline and try to “make it all back” by taking on too much risk and then end up blowing up our trading account.
We must remember to focus on what WE control.
Develop and follow a proven trading system. If you need help, start with my 821x system.
Don’t obsess on whether a trade was profitable or not. Again, you have no control over that. It’s pointless to beat yourself up over a losing trade.
Instead, evaluate how well you followed your trading system. Did you chase a stock that was spiking higher? Did you panic and sell early or get stubborn and hold on too long? Did you break your own rules?
Over time your decision making skills will become congruent with your system. It will become habit. It will become second nature.
Only after you reach this level can you start to gain enough experience to know when a market environment dictates that you deviate from your system. This is the level of the elite performer and is obviously not something a beginner should attempt. It’s just like any other competency. You must start with the fundamentals and internalize them before you can begin to attempt to understand when it may be appropriate to override them.
So learn your trading system. Internalize the rules. Consistently follow your process.
Your trading system should be designed to identify and cut losing trades quickly and let your winning trades run.
Trust that over time you WILL achieve the outcome you desire, an overall increase in wealth.
If you are distressed by anything external, the pain is not due to the thing itself, but to your estimate of it; and this you have the power to revoke at any moment. - Marcus Aurelius