Learn to Manage Your Losses

Let's talk quickly about how we can manage losses successfully, which will improve your trading strategy. Many new investors/traders often avoid losses, tend to forget about them, or even stop opening up their brokerage statements. I saw this countless times when I was running an RIA from potential clients.

The truth is, it's normal for people to prefer to avoid losses rather than confronting them. Think about it; people freeze up in stressful situations and run from confrontations all the time. In my opinion, as well as others, this is deeply rooted in our DNA from early civilization. While you could contribute this to "Fight or Flight" mentality, I prefer to go with the economic or cognitive psychology term for this behavior, called loss aversion that Daniel Kahneman and Amos Tversky first identified. If you want to learn more about it in-depth, go to Amazon or Google, and type in their names for great literature.

The thing is, to be successful trading public equities it's crucial that we don't freeze or avoid losses. You need to act diligently and swiftly at times to manage risk. This, in turn, means you need to learn to lose, and you need to do it quickly!

Losing is part of the game, and the saying "your first loss is often your best loss" is typically true. You can't be afraid to take a loss, the best investors and traders lose 30-40% of the time. So, if they lose that often think about how often you will lose, 50%, 60%, maybe even 70% of the time when you are beginning to trade. Capital preservation is always a top priority, but even more so when you're just starting because you likely have a limited amount of capital.

People make all kinds of excuses not to take these losses too, don't be one of them. I will spare you the numerous examples I've heard because if you've traded or invested even for a little while, I'm sure you've heard them all or thought some of them. Here's the thing, if it's past your mental stop-loss, a technical level broke that you thought would hold, a fundamental change occurred in the company that no longer supports your thesis for the trade -- you need to get out. Your drivers are gone, your edge has evaporated, and you have no business being in that trade now.

So, my suggestion to overcome loss aversion is similar to how others overcome phobias. Open up a brokerage account with a small amount of money, preferably at a commission-free brokerage. While technology is typically lacking at these firms for advanced traders, you don't need this exercise to cost you more than it has to. You can always use a different brokerage that has all the bells and whistles once you're ready.

To start, buy a share of multiple company's that you use or like. Determine your stop-loss parameters, whether that' s a percentage or a technical level of support. When one of them ultimately breaks, sell it. Do this over and over until your comfortable with losing money on positions that don't work. You need to train your mindset that small losses are wins because risk management is paramount in being a successful investor or trader. At some point during the process, you will become desensitized and become numb to losing small amounts, and by focusing on the losses, you will, in turn, learn to let your winners run as well.

When you think about it and start seeing the big picture, this is just a simple math problem behind the philosophy of taking multiple small losses, while letting your winners run. Hypothetically, say each position you have is identical in size (cash value), and you take losses at -3% and sell winners at +8% in your equity portfolio. Additionally, you have six losing trades, to four winning trades. Your losses will equal -18%, while your winners equal +32%, which equates to a +14% gain overall in your portfolio even when your win/loss percentage is only 40%. In other words, you don't need to be the next hedge fund star; you need to manage your risk correctly to succeed. The simple formula is below, feel free to play around with it to suit your trading strategy.

(0.08 * 0.40) - (0.03 * .60) = +14%

In life, there will come times you will freeze or avoid things, and that's okay, it happens to the best of us, but it's not okay to freeze or avoid losses when trading. Become numb to losses, execute like a mechanical machine, and move on to the next trade with confidence, because losses happen often. It's just part of the game.