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Wise Stock Investing is about Much More than Being "Right"
The title may sound strange to some
investors or traders, especially to those that are new
to the subject. Some people are convinced that this
is the single most important thing for success in the
stock market. But the truth is; when it comes to being
a successful investor, how much money you make when
you're right really isn't all that counts. The simple
fact is you won't always be right. Oops. Bad news, right.
It's not something you like to hear, but it's true.
Isn't it? Even though it's possible that some of you
may have met someone, at one time or another, that claimed
to be right almost 100% of the time. And if you haven't
met that person yet, you might run into him or her somewhere
in the future. When you do, be careful. When someone
tells you he or she is always right, in general, three
scenario's are possible:
- You're talking to the world's best
investor / trader
- You're talking to a textbook example of beginners
luck
- You're talking to a liar
Let's take a quick look at all these
possibilities. The first scenario is of course highly
unlikely. Fortunately it's easy to find out if this
is the case. Just take a look at the person's track
record. People that like to brag about being right all
the time, usually enjoy making their point. So they
would love to prove their track record to you. If they
fail to cough one up, they're probably not telling you
the truth.
The second scenario is a lot more likely.
Only a couple of years ago, when every idiot could make
a profit because share prices were continuously on the
rise, it seemed like these people grew on trees. In
todays market you won't find a lot of those people hanging
around. Most of them got more than they could handle
when the bubble burst. And many of them never had the
courage, or the financial means, to return to the game
of investing.
Then of course we have the third and
most likely scenario. In this case, you would take the
same approach as you did with the super investor. You
ask them to show you their track record. The liar of
course will never give you this. Instead they will try
to convince you with wonderful stories. All of which
are probably fascinating. Some would be interesting
enough to serve as a plot for a Hollywood blockbuster
on Wallstreet. However, none of these stories will do
you any good when it comes to making it in the stock
market.
The plain and simple truth is that nobody
can invest for any period of time and be right each
and every time. It simply is not possible. Now that
doesn't mean that anyone telling you they never lose
is lying. It depends on what they're really saying.
They are not saying that they never lose on a trade
or on a specific investment. What they may be saying
is that they never close out a year with a loss at the
end. So how come they can make money every year even
when they lose on some trades just like everybody else?
The answer is simple; they are right more often then
they are wrong. And more importantly, when they are
wrong they limit their losses.
To illustrate this, let's compare the
stock market to a game of roulette. Some people could
easily substitute one for the other. They live under
the assumption that both are simply games of chance.
Others may find this comparison ridiculous because the
two are so vastly different. The two camps would probably
never agree, so let's not go into that discussion here.
However there is something very important we can learn
from roulette.
In a game of roulette the odds are actually
divided in a reasonably fair way. If you were to continue
playing by constantly just betting a small amount, say
$10.00. And you would consistently play the same color,
say black. You would be right 18 out of 37 times on
average. Of course you would also be wrong 18 times.
If you would consistently play the game this way, you
would probably never win much, but you couldn't lose
much either. As a matter of fact if you would just continue
playing long enough, you would eventually lose on 1/37th
of all your bets.
Unfortunately the same can not be said
for the stock market. The odds are quite different there.
Yes, the market can go up and down, and there is no
zero, but there are many more factors to be taken into
account than in a game of roulette. The same strategy
that was described in the roulette example could work
quite well in the stock market, but it could also cost
you everything you've got. One part about being a successful
trader is to be right as often as possible. And even
though you cannot predict the market, at least not perfectly.
You can do your homework by studying the technical analysis
charts and doing some fundamental analysis into the
company. If you know what to look for, this will greatly
increase your chances of being right.
However, you still will not be right
all the time. And that is where both the lesson from
the roulette example and the title of this article come
in. First of all, you have to place your 'bets' evenly.
Stick to the $10.00 example. Don't be persuaded to invest
a significantly large part of your investment capital
into any one trade just because you're so sure this
time. This may work out fine many times, but sooner
or later it will hurt you, and it will hurt bad. You
see it is not how much you make when you're right that
counts. It is what you keep yourself from losing when
you're wrong that really matters in the long run. You
can be right 90% of the time and make some pretty good
money. But it won't do you any good if you lose it all
on the 10% of your trades when you're wrong. Of course
diversification and proper asset allocation can help
protect you, but that simply isn't enough. You have
to know when to get out.
So next time when you're about to make
a trade, ask yourself: "What if I'm wrong".
And then determine a price level at which you will take
your loss and get out. Once you've determined this simple
rule, just stick to it. It may cause you to lose a little
money every once and a while. Even on trades that may
bounce back just one day later. But in the long run
that will hurt far less than the losing trade you so
desperately hang on to, hoping it will recover. Only
to find out that it won't.
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