There are two reasons that most investors quit. The number one reason people get out of the game is because they have suffered a portfolio loss that exceeds what they can live with. The number 2 reason people get out of the game is because they can’t stand the volatility (ups and downs) and uncertainty during a crisis.
Average investors don’t take this into account; successful investors do. Successful investors realise that they have to manage their portfolio in such a way that they can sleep at night. The way they are able to stay in the game during the bad times is by:
1. Avoiding losses that are bigger than they can live with.
2. Keeping the ups and downs within a range that they can stand.
That seems rather simplistic but the Wall Street System (retail brokers and advisors) completely misses this simple fact. They assume their clients have an unlimited pain threshold. The Wall Street System incorrectly assumes that their clients will always react logically instead of emotionally. That’s just another way the Wall Street System doesn’t get it.
We are emotional beings and emotions will play a factor in every decision we make, so we should take them into account from the start. As investors, we have to be comfortable with the ride of the vehicle or we aren’t going to keep it. It is one thing for a car to have a nice ride when the weather is nice outside, but how does it do in the midst of a bumpy patch of road? Does it quickly lose traction in a snow storm? It’s how the vehicle responds when conditions are bad that has the biggest impact on our ability to keep going.
Successful investors recognise that minimising losses is essential to staying in the game, so most of them have developed sophisticated risk management systems to do just that. The average investor might think they are controlling risk by having a stop loss—a predefined price at which they will sell if the investment goes down. Then what? If you ever want to recover that loss, then at some point you are going to have to buy back in. And the market can go down again so that you have another loss. Using a stop-loss can slow down the rate of loss, but it may not keep you within your pain tolerance.
Successful investors control risk at multiple levels providing them multiple fail-safe mechanisms. They may use a stop-loss on an individual stock but they may also reduce the size of their position as the value goes down. They may monitor risk and losses at the sector level so they are considering how a group of technology stocks is doing instead of just one.
They may use controls that would alter the amounts invested in stocks versus bonds versus options or managed futures. They might control risk at the currency or country level. They may only invest in certain types of markets–for instance, they might only invest in stocks if the market is in a defined uptrend. And, if all of those measures fail, they may have a level at which they go to cash.
You can begin the transition from being a frustrated investor to a successful one by recognising the vital importance of minimising losses. The best way to do that is to employ consistent risk management processes at different levels.
(excerpt from “How Successful Investors Tripled The Return Of The S&P 500” written by Jeffrey Voudrie)
Any opinions expressed herein are solely those of the author and do not in any way represent the views or opinions of his employer or any other person or entity.
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