Investment Survival Is Based on Planning
The scariest headlines are often a prelude to a change in the price trend for the stock market, which is why developing and refining a sound trading plan is the best approach to long-term investing.
For example, a CNN headline from March 15, 2022 read: “Dow falls for the fifth straight week.”
The article’s lede painted an even darker picture by noting: “Even with the pandemic, the stock market enjoyed gains in 2020 and 2021. But is the party on Wall Street over?” while adding: “There’s a lot for investors to worry about.”
Of course, they were correct about that particular moment in time. But markets don’t stand still, as the rally which started just a few days after these dark headlines proved.
Yet, anyone who read those headlines and was watching the market might have panicked and sold stocks aggressively just before the market turned around.
But bad trading decisions can be avoided and bad outcomes can be managed through the development of a trading plan. You need a road map that anticipates possible trading situations and offers reasonable solutions.
Fright or Flight
The reason we make bad trading decisions is our deep fear of losing money.
Biology 101 describes the “fight or flight” response to a crisis when an animal or human is faced with a scary situation. Some choose to fight while others flee. A third option is to freeze — to give in to fright, which is the worst response to fear because it never turns out well.
But as a lifelong investor who’s been through countless bull and bear markets, wars, oil crashes, housing busts, and just about everything else that can affect a portfolio, I can tell you that the best solution is to be prepared.
The most successful traders are the ones who survive to trade another day.
If This Happens, Do This
The best way to prepare for any trading situation and to increase your chances of survival in the markets is by following the following directive: if this happens, do this.
By making this the basis of your trading plan you will be able to address most trading situations. For example, when I read scary headlines, I start looking for a market bottom. And when a stock I’ve been following reaches a certain price point on a chart, I make decisions as to whether to buy or sell.
Here are macro-practical suggestions that will help you manage those fears when markets get rocky and keep you in the investing game for the long term:
- Paper Trade. This is the best way to game out “if this happens, do this” scenarios. You can perform this exercise with paper and pencil, or by using a practice account through an online broker.
- Trade in small lots and diversify. Trading in small lots, for example less than 100 shares of any company, is an excellent way to spread your risk. Consider that if you buy 500 shares of a $100 stock (ABC), you’re risking $50,000. If that stock falls $10, you just took a $10,000 paper loss. If you had bought 100 shares and you had spread that risk around by buying small lots of five different stocks, odds are that the $10 loss on ABC would have been a lot easier to swallow. Moreover, if the other four stocks went up on that day, then the hit to ABC might not even have been noticeable.
- Trade what you know. As a physician I am comfortable in trading health care stocks. But I am very specific. For example, I avoid trading health insurance or hospital stocks, because in my experience, there are too many external factors which can make it difficult to discern what’s going on with those companies. On the other hand, I dive deeply into biotech and pharmaceutical stocks. That’s because in my daily practice, I prescribe medications and can often gauge how well they work and how those results may affect the price of the respective drug maker.
Develop Your Trading Plan Further
Once you’ve gamed out your scenarios, work on a set of guidelines to measure the success of your plan.
In my bestselling book,Options Trading for Dummies, 4th Edition, I describe easy to follow principles that form the basis of a sound trading plan.
Here are the highlights:
- Write it down. This simple principle will keep you grounded. Put your trading plan where you can see it and review it regularly.
- Set realistic goals. If you have a small trading account, don’t shoot for the stars. Meanwhile, set up a savings plan that will help you grow your account over time.
- Use your goal(s) as your measuring stick. Set down some specifics. My favorite is to make enough money for something specific, such as a car payment. If you’re not making enough money to meet your monthly goal, a careful review is in order.
- Keep excellent records of your trades. This works for both winners and losers. A monthly review of your trades and your results will keep you on the right side of things. This works especially well in concert with your paper trades;
- Adjust your goals and your plans as your situation changes. If you’ve changed jobs and got a raise, increase your savings plan. If you are about to get married or have to plan for a child’s education, see where things stand and where you may need to go.
Become a Market Expert
You don’t need to write your own newsletter, although that’s how I got started, which is another story altogether. But you should be comfortable with knowing how markets work and how you may need to adjust your approach based on how price trends change. Here are the big things to know:
- Interest rates can and often affect stock prices. Higher interest rates often decrease stock prices, and lower interest rates do the opposite.
- Learn the basics of key market sectors. For example, if you’re interested in the housing sector, get a good handle on how the business works such as the effect of interest rates, the best companies to consider, and if there are other sectors related to housing that make sense to learn about such as building materials.
- Understand how to read price charts. Price charts are usually where the story for a company’s stock comes together. That’s because when investors buy or sell stocks their decisions are catalogued and summarized in the price of the shares. Price charts let you see what that price has been doing for some time.
- Know that price is the ultimate truth. The market reacts with the information it has at any point in time. Sometimes that information changes rapidly and prices change accordingly. When the market is crashing and your stocks are holding up, there is no need to sell them at that point.
- When everyone is bearish or bullish, start looking for a trend change.
Fear of losing money is the biggest negative influence on all investors. But by formulating a sound trading plan, you can manage your fear and your market risk more effectively.
After 35 years as an investor, including a multi-year stint as a manager of other people’s money, I can tell you from personal experience that there is no substitute for taming the enemy within.
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