Managing losses: A very important skill that investors and traders must have 📉😞

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Rule number 1: Never lose money

Rule number 2: Never forget rule number 1

Warren Buffett

Managing loss is one of the most important but can be a tough skill to master. There will always be losses with investing/trading. Everyone has lost before. We make many mistakes when we first started investing/trading. Losses are magnified when we take speculative, outsized and/or leveraged positions and/or with borrowed monies. The ability to manage loss must be a prerequisite to investing/trading.

When the facts change, I change my mind.

John Maynard Keynes

We must have a trade plan/investing thesis before we enter the trade and be disciplined to adhere to it. Should the trade not go according to plan, we need to take corrective action. Avoiding losses is not always possible, successful investors accept this and try to minimize their losses rather than avoid them.

Traders are taught to cut loss as part of risk management. However, many will find it hard to cut loss when required. Pressing “sell” button becomes a very difficult thing to do.

A very common saying is “Cut your losses short and let your winners run”. Retail investors tend to do the opposite: taking profits first and letting losses run. Over time, we realise we are holding many losing stocks. This is akin to having a bucket with a hole. Efforts made in earning profits elsewhere are constantly sucked out by losses. Over time, this makes investing/trading tiring and untenable. We need to recognise the problems in our trading/investing approaches and improve.

Why cutting loss is difficult?

Hope: I am right and I will be right.
Our trade plan/investing thesis can be optimistic and does not consider the plausible (drastic) downside. When the share price falls below buying price, we hope it will rebound. The share price may fall with deteriorating market conditions and/or weakening financial position and prospects of the company. The circumstances have changed and/or we overestimate the capability of the companies we invest in. However, we self-justify ourselves with reasons to hold on to the losing stocks (affirmative bias). We hope the market conditions will get better and/or the company will turn around (one day). We cheer when there is good news and good price actions. We hope things will get better (one day).

What if I am really wrong? Is there a possibility that I am wrong?

We need to recognise that hope is NOT a strategy. The stocks can be languishing with little probability of turnaround. As investors, we need to be objective in holding to a losing position than being emotionally attached to our stocks. We need to evaluate critically:

  1. Are the companies we invested in able to continue to do well?
  2. Are there better investments that we can redeploy our capital?

Huge losses
The bigger the losses, the more difficult we can think properly about what to do next. We may have taken too big a position (or worse, several big positions with leverage) thinking the rally will continue. We are caught unprepared and we freeze.

Cannot lose; fear of permanent loss
We do not like to lose. A break-even or little profit will be good. We do not want to sell for a loss. It looks better with profits (even to ourselves and no one else knows). We want to avoid losses; we have a huge propensity for loss aversion. We are willing to wait to win. However, there is an opportunity cost to waiting and the investment may just decline over time if they are of poor quality.

Self-doubt and loss aversion
It is human nature that when the stock portfolio is doing well, we tend to check on the stock prices and profits made regularly, brimming with joy and giving ourselves a pat for a good job well done. However, when the stocks keep dropping in value, we lose interest and ignore them. As the losses worsen, we self-doubt ourselves. We become despondent. We stop checking and do not want to know the extent of the drop in profits or losses. We do not want to face the reality. Inertia takes over. Without appropriate actions, weak stocks are not weed out promptly and at the same time, do not take advantage of the pull-back to switch and/or add to higher quality positions.

Winners are not afraid of losing. But losers are. Failure is part of the process of success. People who avoid failure also avoid success.

Robert T. Kiyosaki

Be fearful when others are greedy. Be greedy when others are fearful.

Warren Buffett

Often, conviction is a function of our buying price rather than the quality of the companies we invested in and their valuation. We have our conviction and boosted with rising share prices and profits. Conviction evaporates when stocks get crashed and losses swell. Our buying price has created an anchor bias.

As stocks drop, it is best to pick good bargains — buy low, sell high is what we should do. Yes, we may have lost positions but that should not stop us from buying great stocks at attractive prices.

Unfortunately, many sell only when they received margin calls or when they need money. Else, they keep holding to their losing positions.

Why managing losses is very important?

Losses eating profits and worse, capital
If losses are not managed properly, they can wipe out the profits from other positions or worse, a net loss position. It is not sustainable. We cannot afford to be in a vicious loop of saving monies to invest/trade only to lose.

Investing/trading skill gaps
There are investing/trading skill gaps that we must improve on. We have to learn from our losses. We have to learn about ourselves and our approaches to improve thereon. We cannot let the losses go to waste.

Opportunity costs
Capital struck holding on to losing positions can be put to better use by switching to better positions and possibly reducing the losses.

How can we improve ourselves?

Profits increase wealth and happiness, losses bring experience.

Failure isn’t fatal, but failure to change might be.

John Wooden

I have not failed. I’ve just found 10,000 ways that won’t work.

Thomas A. Edison

Take charge; keep scores and learn to improve
If we are serious about making money from stocks, be business owners and treat investing/investing like a business.

What gets measured gets done. A disciplined and systematic approach to tracking how well trade plans are executed and recording every buy and sell transaction is an important first step. Tracking the profit and loss on a weekly or monthly basis force us to focus on how well we are faring and examine the positions for required actions.

This was what I did and it transformed my investing journey. You can read it here and how it has helped me in many ways: One thing I do that transforms my investment/trading journey.

By keeping track, we will evaluate the quality of our investing/trading skills, and our ability to manage losses. It will be a process of self-discovery and taking charge. Slowly, we will recognise our investing/trading patterns and the weaknesses to work on. As we learn, as we improve the quality of decision-making and execution, we should be able to achieve better results.

The only real mistake is the one from which we learn nothing.

Henry Ford

Every adversity, every failure, every heartache carries with it the seed of an equal or greater benefit.

Napoleon Hill

Strong opinions, weakly (or loosely) held
It is an expression describing a framework developed by technology forecaster and Stanford University professor Paul Saffo. He described the process as:

“Allow your intuition to guide you to a conclusion, no matter how imperfect — this is the ‘strong opinion’ part. Then –and this is the ‘weakly held’ part– prove yourself wrong. Engage in creative doubt. Look for information that doesn’t fit or indicators that point in an entirely different direction. Eventually, your intuition will kick in and a new hypothesis will emerge out of the rubble, ready to be ruthlessly torn apart once again. You will be surprised by how quickly the sequence of faulty forecasts will deliver you to a useful result.”

It is a useful default perspective to adopt in the face of any issue fraught with high levels of uncertainty, whether one is venturing into a forecast or not. It is about the ability to embrace the power of definiteness and the power of openness concurrently. And when you act, you cannot be of two minds. You have to commit and proceed boldly. But to understand the world, you have to constantly learn, adapt, and grow, which implies shifting direction.

The illiterate of the 21st century will not be those who cannot read or write, but those who cannot learn, unlearn and relearn.

Alvin Toffler

Knowledge is having the right answers. Intelligence is asking the right questions. Wisdom is knowing when to ask the right questions.

Marc Andreessen, the co-founder of Netscape and venture capital firm, Andreessen Horowitz, is often associated with the term. Being a venture capitalist, he is always looking for start-ups with great business ideas that opposed conventional wisdom. These can be very hard to execute and entrepreneurs must have strong convictions because of the very big bet of time or money or both. However, as the world changes, how will they react?

Be open-minded and humble. Have conviction with flexibility. Be prepared to change and pivot.

Listen to alternative views. We can be wrong with our views. Study alternative views to test our investing thesis to reduce the possible biases that we have.

Don’t take a trade when stressed
Stress can result in irrational and sub-optimal decisions. Everyone’s stress level is different. Stress can be caused by family situations, heavy workloads, or currently having losses. Be very conscious of the stress level and the stress that may be added as we place trades with large allocations. There are always opportunities in the future.

Plan the trade when the market is closed/not looking at the market
Some may find themselves making poor impulsive trade decisions when watching the stock movements. Market actions tend to make us feel FOMO and FUD. One way is to plan the trades when the market is closed.

Start small to get right
Start small to get our investing/trading strategy right. As we improve and invest/trade bigger positions, observe the reliability and consistency of our approaches, learn from mistakes and how position sizing affects us and profitability.

Zoom out; start with a longer time frame
Start to learn using a longer time frame using weekly/daily charts instead of going for intraday trades. Get the game correct before going for the shorter time frame trades.

Determine trading stop-loss levels / continuously validate the investing thesis
Traders should use the available stop loss and trailing stop loss functions in their trading platforms.

Check out the following related articles:
What should investors do when markets are crashing??!!
Everyone is different and needs to have their own investment strategy to succeed.