Most traders and investors experience a similar pattern of profits and losses in their accounts. We work hard to steadily build gains in our accounts and then the market will suddenly reverse and we see weeks or even months of hard work suddenly disappear in just a few days. It can be discouraging and downright depressing and we will berate ourselves for not being more careful. We assure ourselves we will not let it happen again, but of course it does.
I've been trading for about 25 years and I've seen this pattern dozens of times. We enjoy a nice steady rise in a good market and then there is a gut-wrenching give-back that is always larger than what we hoped to avoid.
Unfortunately, if you are a trend trader that rides momentum this pattern of profits and losses is nearly impossible to avoidable. The gains will be slow and steady over a long period and then the losses will come fast and hard in a short amount of time. It is the nature of market movement.
The dilemma that we face is that there is a tradeoff. If we focus on staying with positive trends and good stocks then we can't be too anticipatory. We can't constantly worry that the market is going to fall apart tomorrow and that our great picks will suddenly collapse without warning. We need to stay with good stock picks as long as they are working to fully realize our profits. The more anticipatory we become then the less likely we are to rack up the really big gains that come when riding an uptrend.
The give-back is inevitable. I know that I'm going to lose money when the turn comes but the goal is to build a sufficient cushion of profits during the good times and then to react as fast as possible when the bad times hit to stay ahead of the game.
This pattern is going to happen no matter what we may do and we have to embrace it as just part of the process. Our job is to try to keep the pain to a minimum.
The easiest and most common mistake we make is to freeze when poor action hits. At first, we are inclined to dismiss the weak action as just a temporary pullback so we ignore. Over time the loss starts to build and rather than take some action, we are inclined to sit there and do nothing. I don't know how many stories I heard about traders that racked up huge profits during the internet bubble in 1999-2000 and then sat there for months after the market topped and watched it all disappear. They were frozen by both hope and fear.
The 'give-back' will always feel like it's too much but it is manageable until you let it become too sizable. If you are down 20% from your portfolio highs, you need a 25% gain to move back to even, but if you are down 50% then you need a 100% gain. The task becomes exponentially harder the deeper the hole you dig.
The first step to take when you are hit with a big give-back is to do something. The best timing device you have is your profit and loss statement. When you suffer a big loss that is a warning sign that you need to address. It is not the time to just sit there and tell yourself that you have great stocks and they are sure to bounce back. It is the time to cut your exposure even if you feel like it is a mistake and that you are selling at the exact wrong time. The goal is to not be frozen by inertia.
It can be extremely difficult to overcome the inertia of just sitting and holding on. The best way to deal with it is to make some small sales right away without regard for what you think the market might do. You may not want to dump positions into a big gap down open but start looking for some exit points into some bounces. Reduce those positions even if you love the stock. Tell yourself you can buy it back even bigger and better in the future, but just do something.
It is important to make a distinction between losses caused by poor market conditions and those that are caused by bad stock selection. If the overall market is healthy but your stock picking is poor then you have to deal with that differently than if the overall market is poor and individual stocks are suffering as just part of weak conditions. When you make stock picking mistakes you have to be much more aggressive with totally cutting positions. When you are dealing with shifting market conditions then you need to find some strategic ways to stay partially involved with the stocks you feel are going to bounce back as overall market conditions shift.
I'm holding several stocks in the current poor market that I think will eventually do well but could easily go lower as this corrective action continues. Nothing about them has changed fundamentally but in a market correction that doesn't matter. I could just hold on and rack up some big losses while waiting for them to recover or I could try to reduce exposure, stay vigilant, and look to rebuild my positions as support levels come into play and market conditions improve.
What is important is to raise cash and reduce exposure quickly as a correction takes place. Sell something into bounces, tighten up stops, and dump the laggards. Any action tends to be better than no action. Inertia is the enemy. You may end up selling some stocks at the wrong times and you will certainly be upset when you miss out on some recoveries. But, the increased flexibility combined with not having to make up huge unrealized losses is the goal.
Market corrections and losses are inevitable but as the stoics say 'the obstacle is the way'. Embrace the fact that sizable and sudden losses will occur when the market turns and find ways to use that to your advantage.