Stock moves are based on fear and greed. Unfortunately, basing buying decisions on greed and selling decisions on fear leads to bad decisions. Buying greed and selling fear leads to buying high and selling low. It’s not just the execution price that is the problem, however. Being controlled by fear and greed leads to bad money management decisions. Nearly all investors can state a case where they were extremely confident about a stock — and whether it was based on a strong technical or fundamental picture, greed takes over and money management decisions are ignored.
The stock may be at $10 and you are certain that it will hit $20. As a result, you load up on the stock with a large portion of your assets. Unfortunately, before hitting $20 the stock falls to $7. You were right about the move but wrong on the timing. Because you had too much money invested, you couldn’t stomach the drawdown and the stock was sold for a loss.
The lesson to long-term success is proper allocation of your assets. In our example, if the investor had not loaded up on the stock trade, he could have ridden out the short-term decline and enjoyed the benefits of his correct projection.
Many traders lose everything in the markets because they wager an inappropriate percentage of their trading capital on a single position. Unfortunately, that single position invariably turns out to be the worse of all the holdings. When the trade goes badly, the adverse effect is crippling.
Staying power is important in successful trading. While valuation, trend direction, and timing are all important, proper position sizing is the most critical. With proper position sizing you can be wrong and play another day. With bad position sizing, you’ll end up with big losses and little hope of recovery.
Instead of buying from greed, treat every position like it could be a loser. Yes, there is power in positive thinking but overconfidence leads to bad results. Recall that 80% of all motorists think they are above average behind the wheel. Shun your pride and you will make better decisions. Don’t attribute winning positions to smarts and losing positions to bad luck.
Having a positive attitude about your trading system and your longterm goals are important. However, overconfidence in any single trade can cause you to mismanage it by taking on an undue amount of risk. If you believe every trade will be a winner, the need to confirm that belief may cause you to stay too long in a trade that has moved against you.
It may also prompt you to take a position size that is simply too large. Staying in a trade longer than you should or having too much money at risk is the surest road to disaster.
English