How to Deal With the Trader's Dilemma

 | Mar 18, 2017 | 10:00 AM EDT
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Last week I discussed the two steps to producing superior returns. First, protect capital zealously and keep accounts close to highs, and second, when you identify a good opportunity, be aggressive, press your advantage and try to maximize gains. 

That is an easy theory to state but it is extremely difficult to put into practice. The two steps are inherently inconsistent. If you focus on minimizing losses and keep accounts close to highs, then you will never take on much risk. If you never embrace higher levels of risk, then it is unlikely you are going to produce big gains. 

That is the trader's dilemma. How do we produce outsize gains but control risk? All trading and investing is an attempt to deal with this issue.

If you simply make a series of big bets you may be lucky, but if you wipe out your capital you are out of the game and that is the ultimate disaster. One of the ironies of money management is that becaue the managers may not have their own money in their funds they may not perceive risk in the same manner we would individually. If they produce poor returns and lose investors, they just raise more money and start over. It is very common on Wall Street for funds to take big risk in hopes of great glory, and if it doesn't work they can still go out and raise more funds. 

The way most big funds try to reduce risk is by doing fundamental research. They figure if they know every detail about a company they won't be surprised and will be protected. Unfortunately, even the most in-depth research can lead to major mistakes.

We saw a particularly good example of this recently with Bill Ackman and his Valeant Pharmaceuticals (VRX) debacle. Ackman is known for meticulous research, yet he took a multibillion-dollar loss on this stock. Fundamental research cannot fully protect you. 

The most important thing a trader or investor can realize is that they will be wrong. It may just be bad luck or bad timing, but you will make poor decisions and you will lose money. Once you embrace the fact that losing money is inevitable you can deal with it more effectively.

I like to think of losses as one of the routine costs of trading. A normal business would budget a certain amount of money for an expense such as this. Traders essentially can do that by setting stop levels. Once you hit a certain level you have used up your budget and you must close the trade. There is no other alternative. 

Of course, that is not how people tend to think and react when a trade is going against them. They come up with justifications for why their initial decision was not wrong and why they should exceed their budget for losses. Even worse, they start to look for reasons to add more money to a trade that isn't working.

If you are going to manage risk, you have to be disciplined. That is the heart and soul of it. There must be hard and fast rules that you apply no matter what. This is the mistake that Bill Ackman made. He did not have some sort of methodology to cut his losses at some point. He trusted in his research and refused to take the loss. That can work for you sometimes, but when it doesn't the pain can be enormous.

For many traders the challenge isn't protecting capital and limited risk. The problem is not taking on enough risk. They grow comfortable with grinding out smaller returns and don't push to go for the big win.

One sure sign you aren't trading big enough is if you have no worry. You should be at least a little nervous about a trade. If you are unlikely to suffer any pain if you are wrong, then you are very unlikely to generate a huge profit if you are right.

Good trades should stir up some emotions, but you manage those emotions by being confident that you can handle things if they go wrong. You must be optimistic enough about a trade to reach, but you also must be disciplined enough to deal with mistakes. If you never feel at least a little uncomfortable, you are not trading big enough.

Optimism is a good trait for traders to cultivate, but it has to be combined with discipline. You can be more optimistic when you are confident you have a solid plan for dealing with what happens.

One of the best ways to be more aggressive is to focus on adding to winning trades. When something is working, stick with it and push it. Big gains are all about catching momentum. When you latch onto it, the normal inclination is to hurry and take some profits so you can declare victory. However, when a trade is really working, that is usually the time to add to it and try to extract something extra. You still must maintain your discipline, but riding strong momentum can carry less risk than trying to pick turning points.

Finding ways to be aggressive while minimizing risk is what all investing is about. The first step is to simply be cognizant of the relationship. You aren't going to make big money without risk, but you must manage that risk aggressively to avoid impairing capital.

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