Winning the Trading Game
Should You Quit While Ahead?
Stock Market Investors
Millions of people invest in the stock market -- and for good reason. Historically, such investments made it possible for people to achieve a higher standard of living and to attain financial security: a comfortable retirement, the ability to pay for children to attend college, buying a home, etc.
These long-term investors have encountered good times and bad times. Studies show that active traders fared far worse than those who remained invested over the long term. In addition, those who tried to time the market underperformed buy and hold investors. Sure you want to make adjustments to your portfolio as needed, but trying to time the market has been shown to be a losing proposition for most.
Long-term investors should be concerned with managing risk, but few understand how to do that and tend to ignore risk management. (Readers of this column already know how options are used to reduce risk.)
A far smaller number of people are full-time or active traders. They understand that trading is a business and must generate consistent profits to sustain themselves and their families. For these traders, the goal is obvious: Be certain that the chances of incurring a large loss is near zero because one large loss may deplete their trading accounts.
Some long-term investors also maintain a small account in which they are active traders. This is a viable plan, as long as they are careful not to take too much risk in the trading account.
This may seem to be a trivial statement (but it is not): It is important to have a goal when investing in the stock market. It is even better to update those goals every few years. If you ever lose sight of your goals, it is possible to turn success to failure. Why? Markets do not always rise. Years of bull markets can be followed by bear markets that decimate your account value. Sure, the long-term trend has always been higher -- but if you need your money -- the profits that you earned over many years -- it may not be available during a severe market correction.
When you achieve a financial goal -- perhaps enough money to send your children to college -- protect that money. Take it off the table.
It is a good idea to continue investing for other goals, but do not run the risk of losing a significant portion of your savings. In other words, it is fine to take an acceptable level of risk while your money is growing -- but when you have enough cash to meet your specific needs, decrease risk and protect those assets.
There is one other recommendation that I have for investors. It is not a commonly accepted practice, but it makes great sense when you think about it:
When you reach a level of financial security that you believe will suffice for your entire lifetime; when your investments (and short-term trading) have been so successful that you have enough money (and health insurance) to provide for the future, then you won the investing game. Congratulations.
As a winner, stop playing the game so aggressively. Protect your assets. Sure, you want to earn even more money, but future dollars will be less important than current dollars because the first objective is to meet your needs. Once that is achieved, cut risk by adopting more conservative option strategies. Diversify your assets, do not own volatile stocks; take most of your cash off the table. At this point in your financial life, protecting your assets comes first.
This advice is difficult to follow because we all want to earn as much money as possible. In addition, when we do achieve financial security, it is easy to believe that we are, and have been, successful because of our individual talents. Often we fail to give enough credit to a financial advisor whose guidance set us on an investment path that suited our needs. It is important not to allow your ego to get in the way of making sound financial decisions. If you were smart enough to reach financial independence, then you should be capable of understanding the foolishness of placing that independence at risk.