Are Your Trades Risky Enough to Produce Superior Returns?

 | Jun 23, 2018 | 10:00 AM EDT
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Traders that fail to produce superior returns typically have one of two problems. They either take on too much risk and then suffer as their trades fail to work as planned or they don't take on enough risk and fail to profit sufficiently when the trades do work.

Most traders have a proclivity in one direction or the other. They are either too aggressive or not aggressive enough. They may overreact at times and suffer an occasional foray in the other direction but usually traders that are too risk adverse tend to remain that way.

In general, the best traders tend to err on the side of not taking on enough risk. They are intent on protecting their capital and they don't tolerate extreme levels of volatility very well. There is a saying that there are old traders and there are bold traders, but there are very few old, bold traders. Old traders have learned that it is better to play it safe and stay in the game rather than be too bold and lose their capital.

Quite often the traders that are too bold often are dealing with smaller amounts of capital and have a 'get rich quick' mindset. They are much more intent on producing gains rather than protecting wealth so they would rather go big in hopes of hitting a homerun. Also, when dealing with small amounts of capital it is easier to go 'all in' when there appears to be an edge. Newer traders with limited capital tend to not view capital preservation as a higher level goal.

More experienced traders are much more likely to struggle with taking on sufficient risk. They often complain about selling too early, not having large enough positions or sitting on too much cash. They tend to have more capital and keeping it safe is much more important than producing big returns.

If you are prone to be too aggressive the first question you should ask yourself is whether you have a gamblers mentality when it comes to trading. Are you trading for a thrill and simply hoping to get lucky and win the market equivalent of the lottery? High levels of risk can be very addictive for some people. By comparison a systematic approach to trading which focuses on capital preservation is downright boring at times.

For serious traders, the number one rule of trading is 'stay in the game'. As long as you have capital then you have the potential to produce returns. The beauty of the market is that there is always a new opportunity down the road. Capital preservation needs to be at the heart of any trading strategy if you are going to be in this game for the very long-term.

The more difficult challenge for experienced traders, including myself, is being bolder and taking on enough risk to produce superior returns. If you want to improve your returns, there is no choice but to take on additional risk in some form. You either must take on bigger positions, hold for longer periods of time or own riskier stocks.

The big downside of taking on more risk is that you will have higher levels of volatility. You can not produce monster returns unless you can handle high levels of volatility. Many investors are willing to forego higher returns in favor of small but more consistent returns. That is a subjective decision that each investor must make based on their personal circumstances.

If you desire to enhance your returns by taking on more risk, there are three basic things you can do:

  1. Develop a tolerance for higher volatility.

If you don't give stocks some room to move around, you will seldom be in them for long. Even the best stocks don't move in a straight line. If you sell every 2% pullback you will never hold big winners. You need to develop some tolerance for volatility if you want to produce bigger returns.

My best trades are often disappointments initially. They don't immediately move like I hope and there is a strong desire to throw in the towel, call it a mistake and move on rather than risk a bigger loss. The reaction to volatility is often very emotional and overrules the logic that put you in the trade to begin with.

It is much easier to handle volatility in theory than in practice. You may tell yourself you can handle a 10% pullback without any problem but then when your $200,000 trade is down $20,000 it feels much different and there will be a very strong desire to escape the unpleasantness.

The shorter your time frame the easier it is to control volatility. It is easy for a day trader to limit downside because they don't have overnight risk or the problem of surprise news. They can exit at any time but there is no way a day trader can produce the returns of a position trader that rides a strong trend in good stocks. You have to think in longer term time frames and recognize it will be a bumpier ride than day trading.

  1. Increasing position size.

The other way to take on more risk is to buy bigger positions. This is an issue that I have struggled with my entire trading career. My returns would be exponentially better if I had taken on bigger positions. It was never a question of having enough capital. It was always about the fear of big swings in my accounts.

I've learned to deal with this issue by using an incremental approach. I will make numerous buys and sells of the same stock. Since the time frame for a portion will be much shorter I feel I have better control over risk. It is largely psychological but the ability to make numerous buys and sells of the same stocks makes it much easier to hold bigger sized positions.

  1. Taking More Trades.

Wayne Gretzky once said 'You miss 100% of the shots you don't take'. The more trades you try the more likely you will hit a good one. The key to doing this is to make sure you are quick to dump the losers before they do any real damage. It is very easy to dismiss a trade in a fast moving stock because it seems too risky but I have great results with small positions in a name that scares me a bit.

I read somewhere that Warren Buffett said he has probably made 400 or 500 investments but he made most of his money on about 10 of those. Even a great investor like Buffett has to take a lot of shots to find the big winners.

The more trades you make the more likely you will find a winner but make sure you stay disciplined and don't let the small losses grow too big.

The relationship between risk and returns is at the heart of all speculation. If you want the big returns you have to be willing to take on more risk but that doesn't mean that you can't develop ways to produce better odds.

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