How to Enjoy the Upside with Limited Downside RiskJul 16, 2012
Chad Karnes, CMT
Greater than 50% of the trades many successful investors make wind up losing money. In order to succeed, sound money management and mental strength help them tilt the odds back in their favor and stay profitable.
Imagine cruising down the highway on a beautiful day. The top is down, the temperature is right, and there's no traffic. Life is good!
You are on your way to meet your friends and in order to reach them, you are guided by your sophisticated navigation system. You trust it and follow its advice turning left and right when told. But something doesn’t feel right about the road you are on. It is not paved, extremely bumpy, and you are the only one on it. Your passenger asks, “Is this the right way?” You are thinking the same question, but respond, “the GPS says so, so it must be.” Most of us would continue following the GPS for minutes, maybe even an hour, before we turned around and admitted our mistake which likely sacrificed time, money, and pleasure. Most of us would regret not making the decision to turn around earlier.
No one likes to be wrong, and even more so no one likes to admit it when they are wrong. This is as true in daily life as it is in investing. Unfortunately, in life, arrogance can get us into trouble just as it can in the investing world. When it comes to the markets, there is little room for pride and arrogance and the sooner mistakes can be identified and losses “cut short”, the more successful an investor will be over the long run.
Which Professional Would you Rather Listen to?
Billionaire George Soros, recognizes that no one is ever right all of the time. “It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong,” he once said.
That is why each month the ETF Profit Strategy Newsletter identifies price levels that show when ideas are working and also when they are not. By knowing when circumstances change and admitting to it, investors are able to keep inevitable losers small and shift the odds of long term success positively.
The July Profit Strategy Newsletter identified levels on the S&P 500 (SNP: ^GSPC – News), (NYSEArca: SPY), the Spanish IBEX Index (MCE: ^IBEX), the US Dollar (NYSEArca: UUP), the Euro (NYSEArca: FXE), SPDR Gold (NYSEArca: GLD), the iShares Silver Trust (NYSEArca: SLV), and others. By identifying these levels and knowing when a theme could change, an investor greatly increases his/her odds for success as money management is arguably the most important part of the investment process.
In a recent Bloomberg article from late April 25, 2012 when the S&P 500 was trading at 1391, a “professional” at a respected firm saw the S&P 500 hitting 1500 by year end, or up 7.9%, an admirable target. However, nowhere in the article does this professional mention at what point he would admit being wrong and/or cut his losses.
This is a bad strategy and turned out to be bad timing as well since the S&P 500 immediately fell 70 points within a month and bottomed shortly after, down over 120 points or 9% from his prediction point and 15% from his target. Would you risk a far from certain 7.9% gain for a potentially larger loss? It is smarter to identify what we are willing to risk up front, before an investment is made.
In the May ETF Profit Strategy Newsletter published April 20, 2012, 1380 was identified as a key level between being bullish and bearish. The Newsletter stated, “…support is at S&P 1380 today and will be our soft dividing line between bullish and bearish opportunities”, and continued, “…while above 1380 we will allow for higher prices.”
This professional could have risked only 11 S&P points (1391 to 1380) for his expected 110 point gain (1500), a 10:1 profit to loss ratio. Instead he chooses to risk an unknown and potentially huge amount of S&P points for his 110 point expected gain. Our April forecast would have told him when to cut his losses, and he could have saved a lot of pain, money, and his reputation. Granted there is still time for his “prediction” to come to fruition, but knowing that a break of 1380 would nullify it, would have saved tons of knuckle clenching heartache between now and then and allowed for a much better purchase price.
Knowing when you are wrong and keeping your losers smaller than your winners is crucial to long term success. The ETF Profit Strategy Newsletter identifies important market levels to keep profits larger than losses, and to tip the odds of success in the investor's favor.