by Marc Lichtenfeld, Investment U Senior Analyst
Wednesday, August 1, 2012: Issue #1827
This weekend, I met the father of one of my daughter’s friends. Like dogs sniffing each other, we each asked, “What do you do?”
After I told him about Investment U and The Oxford Club, he was very excited to talk about the market. That happens a lot. And I’m always happy to do so. Usually, the other person wants a stock tip or reassurance that the market isn’t going to tank.
But not this guy. He knew his stuff. He was a former options trader on the Pacific Exchange. Rather discuss the Fed or Facebook (Nasdaq: FB), we talked about mutual friends we had on the exchange floor and told war stories.
There were several traders he knew who made fortunes only to lose it all. Sometimes they made it back. The great ones often do.
But truly great traders are rare. Instead, even good ones blow themselves up with a lack of discipline, feeling too confident in their abilities and opinions.
One Bad Trade…
The first company I ever worked for in this business was destroyed by the owner because of one bad stock trade. Here was a guy who was printing money every year. He lived in a huge house, threw lavish parties and made more money than anyone that I personally knew.
He loaded up on shares of Safety-Kleen (now privately owned) and when the price didn’t go his way, bought more… and more… and more.
Eventually, our whole firm went down. Twenty people were out of a job. Practically everything he had worked for his entire life went down the tubes. Relationships with people he had known for years were tattered. All from one stock! One that he was sure was going to go up.
Or there was the case of Steve, an unkempt but sharp trader on the exchange who was always looking for the fast money rather than the constant drips of cash that came in if you were patient. When times were good, Steve would treat you to expensive dinners, have first row seats at ball games and never let you pay for a drink.
When the dot-com boom turned into a bust, he refused to admit that tech stocks could go down. Every day in 2001, he’d come to work hoping for a miracle to bail him out. It didn’t happen.
Last I heard he was managing a paint store in Wisconsin.
And those are the professionals. You can imagine how many stories there are of individual investors who got burned by a broker or their own greed and lack of discipline.
Three Steps to Avoid Losing it All
So here are three rules that will enable you to go for big gains but should ensure that you don’t bring you and your family to financial ruin.
1). Take Emotions Out of the Equation
If you place a stop order, it will allow you to sell your stock automatically when it turns down. The best part is it removes emotion from the selling decision.
If a stop is implemented, your shares will be sold as soon as they hit the price level where you’ve set the stop. You don’t care why the stock hit that price. Shoot first and ask questions later. You can always buy it back if you decide you still like it. But many times when a stock is falling, it’s falling for a good reason – even if it’s not apparent why at first.
It’s very easy to rationalize why you should hang on to a stock when it’s sliding. Using a stop will help you make a clean break rather than prolonging the agony.
2). The 4% Rule
The Oxford Club recommends never investing more than 4% of your capital in any one position. That way, if a stock drops and hits our typical 25% stop loss, the most you can lose on any one position is $1,000.
If you have a $100,000 portfolio and invest $4,000 in a stock that falls 25%, you’ll lose $1,000. That’s a loss you can easily make up with any one decent trade. But if you start losing 10% or 20% of your capital on any one trade, that’s going to be much more difficult to get back.
3). Don’t Be An Action Junkie
Some people trade for sport. They don’t need the money and they like the action. That’s fine if they can afford it. But for most people, the money means something, so know the reason you’re getting into the trade.
Even if it’s speculative, have a sound reason for it. Maybe the company has a great new cancer drug that, while the stock is risky, could be a 10-bagger if it works. Perhaps a stock is in an uptrend and breaking out to new highs. Or maybe insiders are loading up on it.
Whatever the reason is, be sure you understand why you’re buying the stock and what the risks are. Don’t buy a stock because your brother-in-law, who seems to know what he’s talking about and drives an expensive car, gave you a hot tip.
These are simple but effective rules to keep you in the game. If you can maintain discipline, you’ll have mastered the hardest part of trading – one that many pros have been unable or unwilling to learn.
P.S. I know some of you were frustrated that Amazon.com sold out of my book Get Rich with Dividends so quickly. Fortunately, it’s back in stock. If you were unable to get a copy, you can now order it.How to Not Lose Big Money in the Stock Market,