The secret of great trading and investing results is simple. Cut your losses quickly and let your winners run. You can't help but grow rich if you do that effectively, but putting this into practice is the hardest thing to do in trading.
The problem is that most people fail to make good trading or investing plans. They just buy a stock and hope that it works out eventually. When they do make plans, they lack the discipline to actually execute them.
The biggest danger that investors and traders face is inertia. When we aren't sure what to do, then the likelihood is that we will do nothing. We will hide from the problem and not even look at it.
How does a trader or investor break this tendency toward inertia and inaction?
The answer is by forcing ourselves to take action. One way to do this is not to allow inaction to be a choice. Every stock should be reviewed regularly or after a big move, and then a choice should be made-either we sell, or we buy more. If we don't have the confidence to add to the position, then why are we holding? Reduce the position. If we believe that the thesis for the trade is still in place and that it will be a winner, then buy more.
Since most individual traders and investors don't have a boss looking over their shoulders and forcing them to act, we have to be our own boss and force ourselves to make a decision. Our default response will be to do nothing, so we have to eliminate that choice.
What is most important about this process is that it breaks the inertia. Once you do something, then subsequent action becomes much easier. Most traders have experienced a feeling of great relief when they finally dump a stock that has been bothering them, and they wonder why they waited so long to act.
When a decision is simplified to either buy or sell, then it is easier to implement. One of my favorite pieces of market advice from George Soros. "It's not whether you're right or wrong, but how much money you make when you're right and how much you lose when you're wrong."
That advice requires that you constantly consider the "sell or buy more" decision. Your chances of avoiding big losses are increased, and your chances of making big money are enhanced. It is inevitable that you will make mistakes and buy when you should be selling and vice-versa, but the tendency toward action helps you to minimize the impact of mistakes.
Legendary investor Peter Lynch would use a variation of the "sell or buy more" approach. He reviewed every stock he was holding as if he was looking at it for the first time. If the fundamentals were worse and the price higher, then he would be a seller. If the fundamentals were better, but the price was lower, then he would be a buyer. The important thing was that he was forcing himself to decide and take action. Inertia was not an alternative.
Lynch was well known for being a very active investor. He didn't just buy and hold. When he had a loser, he cut it quickly, but when he had a winner, he would be more aggressive with his buying.
The biggest investing and trading mistake that people make is that they don't have a plan. They hear about a great stock, do some research, buy it, and then wait for the gains to pile up. The only tactic that is employed is hope that they have made a good choice. The plan is to do nothing but wait until they are proven correct.
This approach works often enough that many people keep repeating it. It is similar to what makes a slot machine so addictive. The winners occur randomly but often enough to create the illusion that the jackpot is about to occur at any moment. Eventual funds are depleted, and the game is over.
The reason that buying a stock without a plan is sure to produce suboptimal results is that you will do nothing further. You embrace inertia and inaction when you buy a stock with some vague hope that it will eventually pay off. Platitudes about patience help to reinforce the inclination to do nothing.
Fund manager Lee Freeman-Shor forced his portfolio managers to make a decision when a stock was down 20%. Either sell or buy more. A decision had to be made to break the inertial of doing nothing.
Having a plan is the first step, but the second step is action. Every stock that you own should be reviewed with one question in mind, "Do I sell or do I buy more?"
Force yourself to make that choice. Doing nothing is not an alternative. If you are sitting in a losing position, do you have the conviction to add to it, or are you just holding it because that is the easy decision? Can your money be better used elsewhere? Are you convinced that the market is simply mispricing this stock and that it will be a winner?
We are currently in a very poor market environment, and it is very easy to sit and do nothing. Don't just sit there; make some decisions.
