This is a continuation of the previous post. Within the last post, we talked about how lessons learned from investors apply to investors. As market participants, we genuinely have hardly any control over our destinies unlike most other activities. A tennis games player can always determine whether to be intense or defensive, target opponents’ poor backhand or provide to kill. A businessman, also, can also execute a great deal, such as using discount prices or level to squash opponents or headhunt the best skill on the market to run his business.
But for traders and traders alike, we are in a casino game where we control only 1 lever. We draw it to buy, release to sell, and the length of our draw determines our wager size. Maria, the most beautiful playing golf player still. In other words, as market participants, we can only just determine our entry price, our exit price, and how big is our trade. This game is quite restrictive really. Hence the lessons from the last post would serve to remind everyone that in this game hopefully, we are our very own worst enemies.
The crux of success boils right down to superior analysis and managing our psychology. I’d think that mindset is more important than superior evaluation. Previously, we discussed the first two points about control and style. The final point is about our own feelings Today. Particularly how our feelings would create what Daryl Guppy (the writer of the book Market Trading Tactics) named an emotional stop loss. In my years of investing, I’ve not really thought too much about this. Luckily or unluckily, I really believe I never hit this stop loss.
A psychological stop loss is the money that we cannot afford to lose emotionally. 10,000 or maybe it’s 10% of the stock portfolio. If we were hit by this magnitude of reduction, we feel really bad emotionally and we begin to break down. We cannot think and make stupid decisions rationally. We are extremely likely to sell out everything just, cutting loss at the worst time possible hence, only to see that things recover from then on.
Obviously, this is different for everyone, but we should recognize it’s there. To create things more stunning, let’s devote some no.s. 20k. But we didn’t know this. 25k into a pharmaceutical stock hoping to make 20% since our evaluation showed everything was great and a fresh drug would be released soon.
Lo and behold, the company announced the new drug failed and it falls by 80% in a week. 20k in a week. That is 20% of the portfolio. We just lost a couple of years of overseas trips at a click of the mouse button and we needed that for the downpayment of a fresh car. We panicked and sell out, distributed the bad information with our partner and confronted the music, and then start to see the stock recover in the weeks after.
This is the psychological stop loss. It is very much comparable to a nervous breakdown or a snap. Our psychology makeup somehow works like a rubber band, if we are over-stressed or over-stretched, we shall snap so when that happens, it is rather hard to recuperate. We see this even in friendships sometimes.
Can we accept these friends? So to make sure this never happens, we have to size well really. We need to think in conditions of both absolute dollars and the percentage of the complete portfolio. We would need contingencies also. For me, the rule of thumb would be never putting more than 10% of the portfolio in virtually any single name. Actually, I would do not get close to 10%. If the stock rises very much, then it’s best to sell out a portion from it.
Of course, starting a posture small helps. Starting a new position at 1% and then turn to build up once we learn more seems like a good strategy. Our romantic relationship with money is exclusive and just how we handle it is also unique in the history of mankind. Through the caveman period till society, humans always dealt with physical possessions and very seldom the idea of virtual wealth even as we do today when trading with screens and computers.