It's interesting that the rule, "Never lose money" is so often repeated by Buffet. It's obvious to everyone that the point of investing is to make money, so why does this quote appear in all forms of investment media?
The quote's wisdom lies in the law of percentage changes in stock prices. Very simply, if your portfolio goes from $100 to $50, you have a 50% loss. In order to recuperate this loss, however, you need a $50gain/$50original value = 100% gain, which is an extraordinary achievement no matter how large an amount your investing. The more you lose, the more of a percentage gain you have to obtain to break even. A 75% loss requires a 200% return to get back to your peak portfolio value, or "high-water mark". Thus, the less money you lose, the less of an extraordinary gain you have to achieve to get back to where you started.
Most active investors, in my opinion, intuitively understand this concept. Where traders/investors go wrong however, is by taking on dangerous risks to get back to your peak portfolio value. An extension to this rule is, "Never take on excessive risk in hopes of getting back to even." This is a mistake I've made and I'm sure all active traders have made it at one point in time. If you do this enough times, you'll go from a 50% loss to a 100% loss and be broke. I'd love to hear everyone's thoughts and stories on this, so please comment below if you've ever butted heads or learned to embrace this concept.
The second trading tip I would like to talk about is timing and this one is just as obvious as "never lose money", but it gets complicated very quickly. Simply put, incorrectly calling the top or the bottom can put you out of the game. Renowned hedge fund investors Julian Robertson and George Soros retired after suffering huge losses shorting internet stocks too early in the investment bubble, despite irrationally high P/E ratios for companies with no revenues.
There's a vicious psychological cycle at work here as well, especially if you're a value investor. As the asset price reaches larger and larger extremes, your investment looks more and more attractive, but since you entered the trade too early, you've already incurred a substantial loss. Nevertheless, you decide to put more money to work because the bubble is bound to pop soon or the asset price is bound to rise from its depths of hell. However, unless your timing is perfect, you will continue to lose money and you run a huge risk of going broke. As Keynes once said, "The markets can stay irrational longer than you can stay solvent.".
I'm a firm believer that money is to be made by reversion to the mean, in which assets revert to their mean price from their oversold or overbought categories. However, whenever I put one of these trades on (especially in FOREX market), I'm constantly attune to the fact that the asset may continue to move in a direction against me and I often times have to restrain myself from adding more despite the increased attractiveness of the investment. It's true that most people are damn accurate in their investment thesis but they still lose money because their timing is off.
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"Never take on excessive risk in hopes of getting back to even." A quote we have all heard too often yet we are unable to comprehend it at first. Nowadays, I manage my risk very well (perhaps largely due to it being part of my profession as well) but only after learning it the hard way. My first hard lesson was a penny stock trade (I no longer play penny stocks) where I lost about 52.1% of my invested money at that time. The sad thing is though, it didn't stop there. Luckily, I smartened up and implemented some trading rules and stategies (one being no more penny stocks). I have now made back all of that lost money back plus more. Psychology plays a big role in that manner. In a sense, trading is not difficult, its about management and, in my opinion, being robotic.
ReplyDeleteTiming is the difficult part though. You can use various techniques, whether it be Technical Analysis or Econommic Indicators, to help but you can still never time it perfectly. But I've learnt to never try to catch a top or bottom. Nowadays, if I buy an equity, I will simply hedge any losses thanks to derivatives. People who try to catch falling knives or rocket ships are nuts!
Good writings! *thumbs up*
Hey Davie,
ReplyDeleteProper money management definitely plays a large role in trading, as does psychology. If you don't mind me asking, what do you do in your profession?
Hey Derek, mind if I call you by your name? I work as an Analyst for Bank of Montreal in Canada. The division I work in is Risk Management, I deal with a lot of institutional traders and equity buy/sell side analysts. ;)
ReplyDeleteIt says in your biography that your a student at Villanova? What year are you in, if you don't mind me asking? :)
Very cool! I'm currently a sophomore. I know BMO is a very well-respected firm. They recruit here at Villanova for their investment banking summer internship. I actually talked to a representative during one of our career fairs, but apparently its pretty difficult to get an internship unless your a junior since they want the flexibility to offer full-time positions. I'd love to talk to you more about Risk Management and your day-to-day responsibilities. Let me know!
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