“So what do you think the single most important rule of trading is, Nick?” a friend asked me as we had drinks at the Connaught Hotel in London’s tony Mayfair district.
As a portfolio manager at one of the U.K.’s top hedge funds, he’s a big deal in the finance world.
But that evening, my friend was looking worse for wear after a very tough 18 months.
He had been unwilling to cut his fund’s losses on bearish bets that went against him.
“Don’t lose any money.”
Of course, traders hear this so often…
It goes in one ear and out the other.
But the truth is most of them ignore this rule.
They may claim they follow it… but they don’t.
Instead, most focus on generating the best trading ideas. And that’s where they run into trouble.
Having put so much work into generating an idea, they become reluctant to sell, even if the trade goes against them.
Psychologists call this reluctance the “endowment effect” – the tendency to overvalue anything (including stocks) that you already own.
The One Rule All Top Traders Have in Common
Ask a group of 20 world-class traders how they make money… and expect to hear 20 different answers.
But whether they are fundamental investors, technical traders or commodity speculators, “Don’t lose money” is the one rule they will all have in common.
Take the example of value investor Warren Buffett. He said, “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”
With his focus on global stock markets, currencies and commodities, George Soros’ investment style is vastly different from Buffett’s.
Yet Soros may be even more obsessive than Buffett when it comes to not losing money.
As former Soros Fund Management CIO James Marquez explained…
Soros would be the first one to tell you that sometimes his actions… look like the most rookie, odd-lot, wrong-way kind of thing, selling at the lows, and buying at the highs. But it’s much easier to understand in light of his avowed mission: to be able to come and fight another day. He says: “I don’t want to wake up broke.”
Victor Sperandeo, perhaps better known as “Trader Vic,” best explained the psychological challenges of implementing this rule…
The single most important reason people lose money in the financial markets is that they don’t cut their losses short. It is a curiosity of human nature that no matter how many books talk about this rule, and no matter how many experts offer this advice, people still keep making the same mistake.
The lesson?
No matter how bulletproof your idea seems on day one, a trade can always turn against you for unexpected reasons…
Even if your original analysis was spot on.
So instead of fantasizing about how a trade will work out in your favor, focus on defining your worst-case scenario.
And if you are right, the upside will take care of itself.
Your mission should be, as Soros says, “to be able to come and fight another day.”
I know my investment performance dramatically improved after I adopted this rule many years ago.
I urge you to adopt it as well.
Good investing,
Nicholas
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Source: Investment U