I've been providing insight about trading on a daily basis for almost 20 years now. When I ask readers what advice have I given that they have found most helpful, the most common answer is that my best trading advice is to work to keep your trading accounts as close to highs as possible.
That doesn't sound particularly profound and, like most things in the stock market, it is much easier in theory than in practice. It takes some major effort to do this effectively but if you're successful at it, then there are two major benefits:
- If accounts are kept at highs, then you avoid having to make up losses. There is nothing more unproductive than racking up a big loss and then having to produce gains just to return to where you were. If you lose 50% of your money, you need to double it to just return to even. Think of the time and effort that is required to just recover what you once had. Avoiding those losses in the first place makes it much easier to produce consistent, positive returns.
- Keeping accounts near highs allows for a compounding effect. The secret to long term investment success, like that of Warren Buffett, is compounding. Compounding is the ability to earn additional gains on your gains. That only works if your accounts are on an upward trajectory. When you have your accounts at their highs most of the time, you will benefit from the ability to put a higher level of capital to work and produce bigger returns. What matters is that the account be near their highs. It doesn't matter what stocks you might hold.
The benefits of keeping your accounts as close to highs as possible are obvious but how do we actually do this? It requires time, effort and strategy. An entire book could be written on this topic but I'll summarize some key points.
- It is important to allow for normal volatility. If you are too rigid in cutting losses as you keep your account at highs then you will be stopped out of most trades prematurely. When entering a new trade, it has to be given some room to develop. Typically, I will plan on entering a trade by making a number of partial buys. I will plan on averaging down to some degree which makes it easier to plan for normal volatility and relieves the pressure for overly precise timing. I then trade the position in a variety of time frames. This is diversification by time frame and helps to reduce risk while providing flexibility.
- Embrace the power of selling. Your most powerful trading tool is the sell button. Traders too often think of selling as a significant event rather than just a strategy tool. A sale can be reversed in the blink of an eye and with brokerage commissions now zero in most cases, there isn't any cost to do so. Think of selling as just a form of insurance. If you have to repurchase a position higher then you have simply paid an insurance premium. It is a very cheap form of protection.
Institutional Wall Street actively discourages selling. Even in poor markets we are told to just sit and wait for the cycle to turn back up. It may take years to recoup the losses that occur in bear markets but we are told that timing is impossible and we should avoid it. The truth is that you don't have to be a market timer if you simply focus on keeping accounts at highs.
- Raise very large amounts of cash periodically. There are two reasons for this. The first is to develop the habit of not becoming emotionally attached to stocks. You can always buy back favorites but if you cultivate the practice of going to cash then you will find it much easier to do when the inevitable bear market hits. It is very empowering to sit on the sidelines with your accounts in cash while others are desperately trying to predict when a downtrend will end.
The second reason for going to high levels of cash is that it helps you to maintain a balanced perspective. You can look at the market in an objective and balanced way and then make your strategic decisions. It is good to remind yourself that you don't know what the market will do next and it is easier to do it when you don't have a dog in the fight.
- Losses are inevitable. If you were to graph the returns of the typical trader, you would see a pattern of smaller, regular gains and then some big, sudden losses. Gains tend to come slowly over a longer period while losses occur quickly and suddenly. This is just the nature of the market and it can be quite discouraging when our hard won profits are given back in a day or two. It is going to happen and there isn't any way to avoid it. Embrace the fact. Do your best to prevent losses from growing further, raise cash and then be ready to go back to work. Stay focused on moving your account back to highs. Don't let the inevitable setbacks discourage you from pursuing the goal of having accounts at highs.
There are a variety of strategies and approaches that can be used to keep accounts as close to highs as possible but the key is to make it a focus. If this is your mindset then you will view the entire market in a different way. Don't excuse those stocks that are not cooperating with your goal. Find ways to buy and sell them so you control losses while you wait for your wisdom to be rewarded.