Keep Your Investment Guard Up to Avoid Knockout

Our portfolio results are always a function of our own voluntary choices. Nobody was forced to buy Citigroup (C), invest in mortgage-backed securities or take out a subprime loan. Win or lose, in the investment game, we do it to ourselves. So own that responsibility. You'll never make money if you're always passing the buck.

How is it that even serious, experienced, successful investors can blow up? Simply put, because they drop their guard. They're unflinchingly disciplined — until that one moment when they're not. That's all it takes for a tidal wave to come and knock them out of the game. Indeed, it's the one time you don't wear a seatbelt that inevitably leads to disastrous results.

There's a bit of sage advice that suggests it's better to lose money than make it the first time you buy a stock, because that instills more respect and fear than making a quick buck on the first trade. The problem on those occasions when you do succeed using undisciplined technique is that it reinforces exactly the wrong behavior. Even if you do make money on that particular trade, you're essentially training yourself out of being a better trader.

So when XYZ is 20% against you and the entire sector is weak and you're already heavy into the trade and you know you should take your loss and move on but instead to decide to double down — and it works! — it's not as great of a win as you might think. Although we might promise that our lack of discipline was a momentary transgression, the fact that we "broke the rules" and yet it worked makes us more likely to repeat the behavior in the future. And sooner than later, it catches up and knocks you out of the game.

Recently, a wealthy retired couple asked me to look at their portfolio. At first glance, it appeared airtight, with the majority of their assets in a diversified assortment of stocks, bonds and funds. No allocation was more than 5% of assets and the dividends and interest generated provided a healthy income for their retirement.

But then came the Google (GOOG) holdings, an almost obscene 24% position that had been bought in one crack because the couple was tired of sitting on the sidelines and just felt as if the stock had to keep going higher. Maybe it will for a while. But one day those winds will change. And because they've been rewarded for being undisciplined, that one reckless indiscretion will likely cost them years of savings and consistent returns.

A big part of what I've tried to do over the years is explore the strategy and approach that makes for good technique. And beyond debating the minutiae of whether a 12% or 14% stop-loss order is more ideal, an overriding principle is to keep yourself out of those do-or-die situations where either XYZ goes up or you're going to have to sell your car and start waiting tables on the weekends to make up for the loss.

Of course, that sort of ruin only happens when you bet big at moments of weakness rather than strength. And that's the essence of technique, the "craft" in Tradecraft. You want to take risk, but you want to take the right risk. When the market is confirming my outlook and the screen is green, I'll get aggressive. It's when trades are falling apart and losses mounting that the real trouble begins. Because it's at exactly those moments when your discipline melts away. If those are the risks you choose to bet on, eventually your portfolio will melt away too.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.