THE REASON THAT
pain hurts is because it should. Pain is nature's way of telling you to get out of harm's way. And when the market moves and I'm losing money, it hurts. That kind of pain is the market's way of saying, "You were wrong." And now that so many people are hearing that message from the market, it's time to think about trading losses, what they mean and what to do about them.
While I do the requisite research, and I try hard to be right all the time, I also give myself permission to make mistakes. I'm never surprised when things don't turn out as I expect. Contrary to popular belief, trading isn't about always being right, but about dealing with the inevitable experience of being wrong. The trick isn't to never be wrong about a company, but to recognize when you're wrong and do something about it. As my mom says, "Life is the story of Plan B." This starts with a very basic part of the game: admitting defeat and taking a loss. That's tough for many people to do, because it means putting ego aside. Say you buy stock in SuperDuperTech at 50. When it falls to 40, most people begin the blame game. From election uncertainty to earnings jitters, interest rates to inflation, people will attribute a loss to everything under the sun everything, that is, except their own analysis, which somehow remains infallible.
And here's where that kind of thinking really leads you astray: Since they know they were right and the market was wrong when SuperDuperTech falls to 30, they buy more. "If I liked it at 50, it's a steal at 30," they tell themselves, never even stopping to consider that perhaps just perhaps they've misjudged the situation. When SuperDuperTech falls to 20, it's Alan Greenspan's fault, or it's those pesky program traders. The fact is that the market is never wrong, but we, as traders, often are.
I am neither the The Amazing Kreskin nor Carnac the Magnificent. I can't divine the future, and not every one of my trades is a winner. But unlike tattoos and marriage, stocks aren't lifelong commitments. Having a position go against me is reason enough to reduce my exposure. Politicians and portfolio managers both need to be flexible, and just like the senators on C-SPAN, I hereby reserve the right to revise and extend my remarks. If I liked it at 50 then I hate it at 40. I was wrong. No big whoop. The point isn't to be Mr. Right, but Mr. Right Now. Take your losses and make some changes. If what you're doing isn't working, try something else.
What sinks most portfolios isn't having losers, but keeping them. In my experience, what makes a good trader isn't the ability to be right, but the courage to admit when you're wrong. Every large loss starts out as a small one, and while being wrong doesn't make you a bad trader, staying wrong does. Sure, if you bought MicroStrategy a year ago at its peak of $333, you would have felt horrible taking your lumps at $72.31 just 11 days later. But think how much better that would have been than hanging on for the ride all the way down to $5 and change. Or say it was PMC-Sierra at $245 last September. Better to bail at $92 three months later, or insist that you were right and find yourself at $31.25?
Most people trade to make money, but the game begins and ends with defense. It's the Hippocratic rule of money management: First, don't lose money. So while most people worry about the gains, I focus on the losses. And when I see losses, I cut them short. Losing positions are far less painful after you take them off the table.
I'm realistic enough to recognize that when a stock I liked at 50 moves to 40, it isn't exactly a sign of great strength. Weak stocks tend to stay weak, so I'd be looking to reduce, not increase, my exposure. That involves taking a loss. I might not take the whole loss right away, but I'll take enough of it to stop the pain and protect my principal. If I'm selling the low, so be it. I give myself the permission to be wrong and the ability to change my mind as situations warrant.
But most people will instead wait...and wait. They'll sit on losing positions or even add to them, patiently hoping to get back to even, at which point they'll they sell. That doesn't usually happen at least not fast enough to make it worth your while to stick around. But on the off-chance that a losing trade does rally back to your purchase price, bailing out is another mistake, since the rebound is usually the best time to be getting back in or even doubling up your exposure. Trading is about being a fair-weather friend.
When there is pain in your portfolio, you've got to make decisions. Ignoring the problem isn't the right decision. The quickest way to stop the pain is to stop the losses. That starts with taking some. While I don't have a set percentage at which I bail, when a stock of mine is hurting, I generally get rid of it and move on. I'll trade away some upside potential for some downside protection in a minute. Doesn't mean I'm a bad person or even a bad trader but a realist. In order to succeed, you must survive. Learning to take a loss once in a while is simply part of the game.
Capitalistpig.com, a Chicago-based hedge fund.>