The thoughts of others
Were light and fleeting,
Of lovers’ meeting
Or luck or fame.
Mine were of trouble,
And mine were steady,
So I was ready
When trouble came.
– Charlie Munger
Investing in the stock market is as much about conquering oneself as conquering the markets. We consider greed and fear to be our arch-enemies, recognizing that both impact our ability to think rationally. Even those who hope to think rationally and who are aware that the best results in the stock market emanate from rational thinking often succumb to temptation and panic.
So how can we avoid acting irrationally and succumbing to greed and fear?
First, we must recognize that we tend to create the circumstances that lead to irrational behavior. Perhaps we decide to risk too much on a single trade, perhaps we over-leverage, perhaps we borrow from a home equity line of credit. Whatever the reason, an unexpected market event can lead to a decision between holding existing positions at the risk of experiencing continued losses or capitulating and banking losses.
Next, it is imperative that we are willing to hold cash in the absence of compelling investment opportunities. At Stock and Option Trades, we have been emphasizing a heavy cash position for almost 6 months. Indeed, in last week’s commentary we pointed out that we expected one last surprise before a spring/summer rally and last Friday’s big down move certainly appears to have taken most by surprise. In this week’s Market Commentary accompanying the Trade Alert, we will highlight when we believe the optimal buying opportunity is.
Another way of mitigating risk of surprise from a market event is to employ substantial hedging, which is another approach we have been advocating for many months on any positions opened. And one of the most important temptations to avoid is leverage. Too many examples in history have highlighted how excessive leverage leads to demise when unexpected events occur. Even the most conservative investors can become paralyzed by losses due to excessive leverage.
It is imperative to realize that the effects of a mistake do not necessarily stop with the mistake itself. A loss at one moment in time may diminish confidence and may result in one taking a smaller position on another investment that may be a great opportunity. This creates a chain reaction, whereby rates of return suffer from reduced exposure to the market at the precise time when greater risks are warranted.
So how will you know at times of uncertainty when to add to a position and risk greater market exposure or to remain with a position? And what is the difference between adding to a position and scaling in and adding to a position and averaging down? Why is one a great strategy and one a terrible strategy?
First of all, our future successes stand on the shoulders of our former successes. If the past successes are mediocre, the next ones lie on weak foundations. In contrast, great skyscrapers can be built upon strong foundations. Knowing that the right mix of ingredients led to success in the past means maintaining the same discipline and patience in order to create future successes. It also means planning a trade well.
The primary difference between scaling into a position and averaging down in a position is in the planning stages, prior to trade entry. Averaging down usually means a position has been opened but is going the wrong way and the trader – caught in the emotion of the trade – decides to allocate more capital than originally intended to the existing position in order to double down. This action results in a violation of risk management principles and quickly puts the trader in one of those stressful situations that can lead to panic.
In contrast, scaling in means a trader pre-plans how much capital will be allocated to a given position and decides to place a fraction of the capital on the initial position. If the position goes wrong, a pre-identified trigger point is used to allocate further capital. And perhaps one last capital contribution is made on a further pullback. At that point, the trader has followed a pre-set plan and can patiently wait for the position to mature.
In short, the difference between scaling in and averaging down has already been made before any capital is at risk. The profitable trader has a plan. The average-Joe trader has none.
To reap the rewards of the stock market, think of every decision as if your entire capital in the world was riding on it. Would you still place the trade? Focus on being a low-risk money manager, keep your standards high and wait for opportunities. Think independently even when others question your decisions and a position isn’t going as well as you had first hoped. And remember, this journey is a long one and the sprinters usually give up before the marathon is even half done – prepare yourself for the journey and the journey will be kinder to you.
