The look on his face was painful.
I was in Miami with my son watching our favorite college basketball team, the Duke Blue Devils, play the Miami Hurricanes.
It was a close game that went down to the wire, but Miami was able to pull off the upset against Duke.
It wasn’t a big game for Duke — not part of a tournament or anything like that — but it was my son’s first time watching Duke play in person, so it meant a lot to him when they lost.
I realize taking losses isn’t something we, as people, do well naturally. It’s a learned habit … and it’s vital that we learn to not be discouraged by them…
There’s No Such Thing as Perfect
When it comes to investing, we are all going to have losses in our portfolio. It’s inevitable, as no system is 100% perfect.
But I’m not talking about the smaller 5% losses here and there, or even 10% losses.
The ones we have to learn to deal with are the ones that keep us up at night — the ones that may have blown up a portfolio or two.
You might ask why this is a topic now as stocks continue to crest new highs almost every day.
Well, some of the worst losses come at high points in life.
Before the NCAA season started, Duke was ranked as the No. 1 team in the country. Here we are a few months later, and they have lost eight games and are ranked No. 17 in the country.
No one paid attention to Duke’s struggles until they started losing, and the same goes for the markets.
Yet markets continue higher because nothing is pressing at the moment, and they will continue to climb until they simply stop — and that’s when it will be important for you to know these three simple steps I have for you today…
Invest With Confidence
The first step in dealing with a trading loss is to simply validate the loss.
Go back and look at why you made the trade to begin with. Think about the parameters that triggered it or the fundamental case for owning it, and figure out when that went wrong.
Maybe (and more than likely) there was a better exit point where it became evident these trades weren’t going to work out, and you could have walked away with a much more modest loss.
If that is not the case, then maybe the second step will help you more.
The second step is to evaluate your position management.
Oftentimes, a loss is felt more than it should be because you were overinvested in that specific trade.
That’s why you should always, regardless of how confident you are in one trade or another, keep position size to where a sizable loss doesn’t blow up your portfolio.
You can help manage this best by having an effective exit strategy.
Whether that’s a stop-loss or an exit trigger, it can help you define your risk … not necessarily by the amount of capital you have invested, but by the amount of capital you are risking on the trade — i.e., the difference between your entry price and the stop-loss.
Lastly, the third but most important step is to keep your emotions out of it.
A bad loss can really eat at your emotions and cause you to make decisions you otherwise wouldn’t have in future trades because this one bad loss scarred you. You end up either avoiding trades altogether or exiting too early.
The only way to avoid this is to follow Steps 1 and 2.
Then, once you realize why that bad loss happened and have better position management, the odds of it happening again are smaller because you have the right measures in place to prevent your portfolio from blowing up. Now you can get back to investing with confidence.
Don’t Be Afraid to Trade
Now that you have these three steps in place, you have rationalized your loss to the point that it should no longer feel like a personal loss, but rather a mistake that you have corrected.
Remember, losses are unavoidable in any trading system, so there is no point in being afraid to take a loss of a reasonable size.
And by following these three simple steps, you have minimized the risk of taking a substantial loss on future trades and ensured that one loss won’t ruin your portfolio.
If you don’t have an exit strategy, this historic rally is the perfect time to put one in place.
Chad Shoop, CMT
Editor, Pure Income