Never focus on making money. Instead, focus on protecting what you already have.
When most people begin investing in the stock market, they believe their success depends on finding the best trading method… when, really, the most critical skill required for success is risk management.
You can do just fine with a mediocre trading method and sound money management, but you will eventually go broke with the best trading strategy and poor risk control.
Unfortunately, most novice traders spend little time developing this skill and learn this fundamental the hard way.
Know Your Exit Before Getting In
I’d like to share with you the single most important rule of investing.
The key to making money in the stock market is knowing at what point you’re going to exit before you enter.
Identifying how much you’re willing to lose if the trade goes against you.
Why is this so important? Because, when you’re analyzing a trade and weighing the pros and cons, deciding whether to invest or not, you’re being objective. As soon as you make the buy, you’re committed… and you’re emotionally involved. Your view becomes biased.
When the trade goes in the wrong direction, you’re likely to rationalize the situation.
“At these prices,” you can tell yourself, “the stock looks even better.”
And you can end up holding a losing position too long.
By deciding what you’re willing to risk before you enter the trade, you remove emotion and bias from the equation… and you limit your losses.
Like most traders, when I was first starting out, I believed I had a good grasp of the markets. I was certain, for example, that the euro would appreciate against the U.S. dollar. I opened a forex trading account, something I was unfamiliar with at the time, and entered a leveraged EUR/USD long position.
For more than a week, I watched as my account increased in value, feeling confident about my trading prowess and believing I was the next Stanley Druckenmiller.
Then the momentum shifted. First, my profits were a little smaller, then there were none, and soon I was deep in the red. All the while, I was angry at the market, thinking it was crazy, and believing every day that was the day things would turn around and my position would again be profitable.
In the end, I lost 40% of my trading account before I finally called it quits. I would have lost more had I stayed in the trade longer.
It was a painful lesson, but ever since I’ve known at what point I am going to get out before I get in. And I hold that line.
How To Set Your Stop-Loss The Right Way
A stop-loss can be a great tool to help you manage the downside risk of a trade… if you use it correctly.
My friend Tom didn’t.
Tom believed that the futures markets were overestimating the growth of the U.S. economy… so he shorted the S&P.
His thesis proved correct. Three months later, when the data came out, the market dropped, and Tom closed his trade… with a loss.
How could this happen if my friend was right about the market? Because he didn’t set up his stop-losses correctly.
Tom took a long-term position based on an idea that proved out, but he didn’t figure in the short-term risks. Too afraid to lose money, he set up his stop-losses too conservatively and got stopped out of his positions every time the market moved.
The lesson to learn from Tom’s trading mistake is that you must allow enough risk for your trade to work. How do you figure how much risk is enough? First you determine the point at which your thesis is proven wrong, such as major support or resistance. That’s where you set your stop-loss.
Then decide how much you’re willing to lose on the trade—your pain threshold.
Only when you know those two things can you calculate your position size. Most novice traders approach the question the other way around. They start with position size and then set the stop-loss at their pain threshold, instead of placing it at the level where their thesis is shown to be wrong. The market doesn’t care about your risk tolerance, but it cares deeply about the support and resistance levels.
The Secret To Effective Portfolio Risk Management
Effective risk management can be surprisingly easy. Whole books have been written on the topic, but, in fact, one simple rule can be the key:
Never risk more than 1% of your capital on any single trade.
With no more than 1% at risk, it should be easier for you to keep your emotions in check. No single bad trade can do much damage. You may (will) still incur losses, but they won’t throw you out of the game.
There is nothing special about the 1% figure. You could use 2% or 0.5%, depending on the size of your portfolio and your investment strategy. The secret is setting a strict loss limit on every trade.