Ask experienced investors what separates survivors from casualties, and few will mention a secret formula. They talk about risk control and temperament. Today, opening an account on any of the popular Trading Apps takes minutes, and a Demat holding can be set up from the comfort of your sofa. Access has become effortless, but protecting your capital still requires deliberate effort. Markets will test your patience, your nerves and your rules. This article explains how to decide how much to risk, how to prepare for losses and how to keep emotions from steering your decisions.
Decide How Much You Can Afford to Risk
Before throwing good money after bad, partition your finances into layers. The first layer is an emergency fund that can cover you up to six months of expenses. The second layer is insurance coverage for health and life. The third layer is savings for your immediate needs such as school fees or a house down payment. That which is left over from these three layers can be considered for equity exposure.
The order is important since money that you can’t afford to lose will cloud your judgment anytime you need to make a decision. A person who has invested in his monthly rental fee will sell at the first sign of trouble, while a person who has invested from his surplus earnings is more likely to hold steady until prices rebound. Be realistic about your earning ability, dependents and liabilities before choosing your risk capacity.
The Logic of Position Sizing
Position sizing is about deciding how much to put into every idea. A popular position sizing technique calls for having only a small percentage of your overall portfolio at risk at any given time. If a person is willing to risk only one per cent of his overall portfolio on any given trade and has a protective stop that is five per cent below his entry point, then the position size should be around one fifth of the overall portfolio. The math is simple but it creates the room for humility necessary to make money in the markets.
Savings of small percentages allow an investor to absorb a series of losses, which is inevitable in investing. Taking a large position on one deal turns a sure loser into a panic seller. The dangers are compounded by correlations. Having three shares of banking stock is no different from having one large banking share, so diversify widely both in terms of sectors and sizes.
Understanding Your Psychology
Man is not a rational creature. We love the profits but hate the losses and this often leads us to hold on to losing positions too long and sell our winning positions too soon. Recent happenings are always more important that anything that happened before. After a winning streak we believe the skies are clear but after a losing streak we believe the earth has opened.
Recognise the psychological barriers as you trade. The most common psychological problems include; overconfidence during winning streaks, revenge trading during losing streaks and the temptation to jump on every hot tip that is available. Once you have identified your triggers it will be a lot easier to rein them in. When the urge hits you to do something irrational ask yourself what it is you want to achieve.
Build a Written Plan and Stick to It
Your written trading plan is your biggest ally against the murky waters of human emotions. The plan should state your objectives, time frame, asset allocation, position sizing as well as your entry and exit criteria. When the markets turn ugly you can go back to this plan and remind yourself of the basics.
The plan should also have a review strategy. You may decide to review your portfolio annually or change positions if fundamentals start to change. Avoid changing your game plan in the middle of a market tempest since the odds are against you of making good decisions when the markets are closed. If you must change your plan do so calmly on a weekend after you have had a good night’s sleep and write down the reasons for the changes.
Learning From Near Losses
Losses are tuition fees so focus on ensuring that every loss is small and every win is large. Keep a simple trading diary that will record the reasons for trades, expectations and results versus expectations and lessons learnt. You will be surprised at how easily patterns emerge. You may for instance discover that you are always buying at the peak of rallies and selling at the bottom of corrections.
Discuss your trading activities with trusted family members or friends or seek the assistance of a good financial adviser. Avoid discussing your finances with random friends on line who will entice you to open a brokerage account with them. Everyone who wants you to invest with them is lying about the risks so question everything. Reputable advisers will always caution you about the dangers of investing.
Staying in the Game
The art of staying in the game long enough to make profits is the most important lesson for every investor. Ensure that your capital is well protected through good position sizing. Maintain a good financial base outside the stock market and take heed of your emotional boundaries. Profits are easy for those who know how to stay in the game, since patience is often rewarded by the market.