- Don't overleverage...
- Don't overconcentrate...
- Admit when you don't know (and never trade until you do).
Following these rules (any rules) is much harder than understanding how to analyze the market, sectors, or stocks. The smartest traders and investors on earth get killed because they can't follow them.
As simple as these three critical principles sound, they can be the most difficult to follow, because they don't deal with analysis and logic. Instead, they deal with human nature They require that you overcome human nature.
Let's take them one at a time...
Rule 1: Don’t Overleverage
Overleveraging means taking too much risk than is good for you, given your temperament and situation.
It is something we do when we get greedy about a position we believe we're “sure” about. Or when we feel like we need to make up for a past mistake (usually a past mistake that involved overleveraging!).
We can become too confident about a situation, to the point where all we can envision is a future stock chart exploding in the direction we want it to... and the file of money we'll have if and when it does.
Sometimes we don’t even consciously understand that we are playing a position too heavily until hindsight lets us see what we’ve done. It's like the way a person remembers something embarrassing they did when they drank too much the night before.
You can have the most successful system on earth, with the greatest track record, but overleveraging on just one single position can render that system null and void. Meaning, it is no longer a system. Worse, a bad loss from overleveraging can cause a domino effect that easily spirals out of control. Then, you could find yourself spending the next several trades trying to make your money back from that one loss.
Rule 2: Don’t Overconcentrate
While overleveraging involves taking too much risk, overconcentrating means irresponsibly choosing your position size. It has a similar effect in that it negates the effectiveness of any system.
Here, you might be able to handle the bigger sized position. But if you’re using a system to invest, make sure to also systematically “up the ante”. This means having a set of rules you follow to increase position size. That means predetermining by how much your position will increase and under what specific circumstances it will happen.
Ideally, you should have a position sizing system that allows you to increase your position, but not by too much. Be careful that you don’t invest more than the usual amount just because you “have a good feeling about this one”.
In any educational program I've ever created, I make it a specific point to stress the importance of position sizing. I also recommend you learn a risk management strategy that uses options. Even if you don’t trade options, I suggest that you consider trying it, because it reduces your risk down to a fraction of what it was without making you sacrifice upside.
This next and final principle sounds simple, but because it also involves emotion, it can be difficult to put into practice.
Rule 3: Admit When You Don't Know (And Never Trade Until You Do).
A good trader knows when to say, “You know what? I’ve lost my rhythm. Something may be wrong, or perhaps everything's fine. But I’m going to stop for a little while and just sit and watch until I feel my mojo returning.”
Commercials for the lottery aside, you don’t always have to be “in it to win it”. Not losing is as important as winning, so if you don’t know, just stay out.
If it means sitting in cash, so be it. As I've told you many time cash is a trade too.
Unfortunately, most traders have to learn about this one from experience, which is one reason it makes sense to keep your risk low and to have set rules for taking a break from trading when you are down by a certain amount in a certain period of time.
Trading is fun -- especially when you’re making money. The pitfall though, is that when a trader makes money too often, he can become too confident. He can begin to feel bullet proof. That's a mindset that usually ends up leaving gaping holes in your portfolio.
Sometimes it isn’t a matter of being careless. I mean, you can pick something apart and go through every position with a fine-toothed comb every which way there is...
... and STILL lose on several trades, one after the other.
Then, you start to second guess yourself and ask what’s wrong. Sometimes a person will trade to try to “make their money back” (as if the financial market knows or cares who you are or what you’ve invested).
The market doesn't care. But I do. That's why I want you taking each of thee rules to heart.
Until next time,