Doc's note: There’s one thing nearly all investors fail at… letting their winners ride and cutting losers short.
Today, I'm sharing an essay from my friend and colleague Steve Sjuggerud. He explains why it's hard to cut losses and how knowing when to get out of a bad trade drastically improves your portfolio results.
I (Steve) invest in a simple way...
I'm willing to concede a few battles to win the war.
This is a simple idea. Unfortunately, most investors can't do it. It goes against our egos to simply admit that we might be wrong and move on. We think we need to be right EVERY SINGLE time.
What's the war we're trying to win? Growing our net worth.
And to grow your net worth, you have to start by knowing that you are NOT going to win every time in investing. It's not going to happen...
You are going to win some, and you are going to lose some. Let me repeat that last part: You are going to lose some.
You need to be OK with this.
Knowing that you are going to lose some, you have a simple mission: You must take steps to make sure your winners are larger than your losers.
This is where nearly all investors fail. But that doesn't have to be you...
I turn it into a simple math problem... I make sure my losers stay small by cutting them early. And I let my winners grow.
It's the old saying... "Cut your losers and let your winners ride."
Let's take a quick look at some easy math so you can see how important this is...
Let's say you made three consecutive trades. By the time you closed out, the returns were: -10%, -10%, and +100%.
How did you do?
You might think that you did poorly... Your median return was -10%. That sounds terrible – no question.
Also, you were wrong 67% of the time. That sounds bad, right? Who wants to lose money on two out of three trades?
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But I would take these three trades any day...
Here's what really happened: In this scenario, $100,000 invested would have turned into $162,000.
You would have made a 62% return on these three trades. And that holds true regardless of the order you placed them in...
$100,000 would have turned into $90,000 after the first losing trade, and then $81,000 after the second losing trade. Then it would have doubled to $162,000 after the winning trade.
Flipping the order around gives the same result: $100,000 would have turned into $200,000 on the first trade... Then it would have fallen to $180,000, and finished at $162,000.
How does turning $100,000 into $162,000 in three trades sound to you? It sounds pretty good to me!
All it takes is cutting your losers early and letting your winners ride. You made sure your losses stayed small... And you let your winner ride all the way to 100% gains.
So how do you trade? Do you cut your losers early and let your winners ride?
If not, then it's time for a change... You need to realize that it's OK to lose some battles on the way to winning the war.
Here's the thing... You will not be right every time. I promise. What matters is what you do when you are wrong.
What is your plan? Most people don't have one. And that will crush them, eventually.
If you don't have a plan, I suggest changing your thinking about making money. Set yourself up for sustained success. Start cutting those losers early... and letting those winners ride.