SmartInvesting.ca

List of Articles

Successful stock trading requires a system to preserve capital and a firm control over ego and emotion

by Wayne Cheveldayoff, 2003-07-06

With many stock market pundits saying that a ‘buy and hold’ strategy will not work in the coming years and the only way to make money in stocks is to ‘buy and sell’, individuals may be tempted to try their luck at picking stocks and playing the swings in the market.

However, picking stocks or picking the time to buy them is only the first part of a winning strategy. To be successful at this game requires that investors must also put in place a system to preserve capital and commit to a discipline that takes ego and emotion out of the equation.

Whatever stock-picking system you use, it is important to also implement a system of minimizing losses, or preserving capital, in the event that you are wrong. It really amounts to being quick to cut your losses while letting your winners run.

It is surprising how many willingly experienced the opposite, as those who held on to Nortel shares from $100 to under $1 can attest.

So why do many stock investors hang on to a losing trade?

One reason is emotional--they can’t sell at a loss. It may also be because they have spent so much time and effort in identifying what they think will be a winner, they find it hard to acknowledge that they have made a mistake. In other words, they think they are right and the market is wrong, and if they wait, the market will get it right and the stock will recover.

This is what professional traders refer to when they talk about ego, as John Hayden does in his excellent book entitled The 21 Irrefutable Laws of Trading: “How do you become a highly disciplined trader? The answer is by mastering your ego, creating faith, and gaining confidence. You must acknowledge how crucial discipline is for your ultimate success. Once you acknowledge its importance, you need to be firmly in charge of your ego, have unshakable faith that the outcome you desire will be accomplished, and the confidence that your methodology will work. Then you start the process of changing or creating the necessary beliefs that will empower you to become a highly disciplined trader.”

It usually boils down to listening to the market, not inner voices and emotions. When the market says you are wrong, take your lumps and save your capital to try again another day.

The most important technique for preserving capital is the use of a stop loss. This involves drawing a line in the sand and saying, “If the price of the stock crosses that line, I will sell it no matter what. No excuses.”

You must first decide where that line is. Often, traders use a rule of thumb of 10 per cent of the original purchase price. For example, if you buy a stock at $10, you would sell if it goes down through $9.

Using a stop loss in this way does run the risk that the stock may trade down, trigger the stop loss and then go up again. This does happen. However, using a stop loss will prevent destructive situations where a 10 per cent loss quickly turns into a 30, 50 or 80 per cent loss, from which it is very difficult to recover.

A common mistake investors make when a stock drops is to buy more, thinking that it is even more a bargain than it was before. Such ‘averaging down’ can work sometimes. But more often than not, the stock is going down for a reason, even if there hasn’t yet been a public announcement or event that justifies it, and putting more money into the stock at a lower price has little chance of success.

It is definitely not an approach used by people who get rich through trading, like billionaire George Soros. Rather, they press their bets when the trade is going their way—in other words, adding to the trade when the market is confirming they are right, not when they are wrong.

To trade successfully, you need to have an opinion. But you also have to listen to what the market is telling you.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at wcheveldayoff@yahoo.ca.

The URL for this page is http://www.smartinvesting.ca/articles/20030706020100.html .


©2003 Wayne Cheveldayoff