The Formula for Limiting Losses
Editor’s Note: Today, we’re running another important message from the CEO of TradeSmith, Keith Kaplan.
I was great at buying the right stocks but was still a terrible investor. Maybe it’s the same for you? For example, in October 2016, I bought Advanced Micro Devices (Nasdaq: AMD). I looked like a genius.
AMD gained over 1,000% since I bought into the stock. But I missed all of those gains! So much for looking like a genius.
Simply put: I trusted my gut. And it cost me a lot of lost gains.
So how do we stop that from happening to you?
Use a Formula
Quite simply, you keep your emotions out of any investing decisions (Ted and I talk about this in the 2021 Peak Profits Summit, which you can watch here).
That’s easier said than done, of course … unless you follow a regimented process for understanding exactly when to buy a stock, how much to buy and when to sell it.
It’s all encapsulated in this formula…
You see, two economic Nobel Prize winners in behavioral finance — Richard Thaler and Daniel Kahneman — made some groundbreaking discoveries. One is that we “risk seek when we’re losing.” In other words, we rationalize our decisions after the fact and don’t admit our mistakes.
For example, when a stock is falling, you say to yourself: “I’m going to buy more on the dip … this stock will come back and my break-even price will be lower … it’s just a paper loss.”
Really, what you’re doing if the bull thesis behind the stock has disappeared is adding more risk to your position. You are “seeking out more risk” by buying more.
But what you should do is look at momentum. It’s the single most important factor when investing in stocks. When a stock has a confirmed uptrend, it is more likely to rise in the short term. When a stock has a confirmed downtrend, it is more likely to fall in the short term.
By buying more of a bad stock as it’s falling, you’re taking on risk. You’re setting yourself up to lose more money.
So how do you combat that? With these three steps (and several others we discuss here):
Step No. 1: Don’t react emotionally.
Step No. 2: Follow the formula.
Step No. 3: Apply the strategy.
What About When We’re Winning?
Thaler and Kahneman’s second discovery is perhaps even more interesting. They found that we are “risk averse when we are winning.” Basically, we sell our winners to lock in our gains. No one wants to experience a round trip, so we get off the track.
But in doing so, we’re actually hurting ourselves.
Remember, when a stock is rising and it’s in a confirmed uptrend, it’ll keep rising for a while. So this is the BEST TIME to either ride the winner higher or add more money to the position to take advantage of its short-term outlook. Few ever do this.
And that leads me to our (TradeSmith’s) discovery of the single most important number when investing in stocks AND why it works. This number is the formula I showed you above for “VQ” — which stands for Volatility Quotient. It solves many problems that individual investors face today.
It’s a measure of historical and recent volatility in a stock, fund or crypto. And that measurement is really focused on the moves they make.
Here’s what it tells you:
- When to buy.
- How much to buy.
- When to sell.
- And how risky that stock is and the movement you should expect.
In short, you don’t ever have to worry about making the wrong emotional decision again.
Let me leave you with a single nugget that may change your stock investing journey forever. It certainly has changed mine…
What Thaler and Kahneman are saying is that the trend is your friend. Understand it and act accordingly.
The VQ is the easiest way to do that.