Basic Thoughts on Downside Risk
Okay, so you’ve scrimped and saved and put together you first investment stake, and sent the money to your favorite exchange. You read my book, so you are committed to being an “investor,” you are not going to be a “day trader”; what do you think is the most important thing to remember as you embark on your new investment career? If you guessed any of the following you were wrong: “Buy low sell high”, “don’t chase the crowd”, “chase the crowd”, “technical analysis will make me rich”, “fundamental analysis will make me rich”, etc.
The answer is “control my downside”. Warren Buffett likes to say; “Rule number 1 is: ‘don’t lose money’; rule number two is: ‘don’t forget rule number 1’”. The most important thing you can do for the long term health of your portfolio is to have a plan to handle your losses. While in college I once heard a friend talking about a trade he had made, he said: “I can’t sell this position, I lost too much money on it!”. Only looking back do I realize it was insanity.
The first element in controlling your downside is picking the right investment to swing at; legendary investors handling large pools of capital, again like Warren Buffett, are known to invest only a handful of times per year, and only when something really outstanding catches their attention. In fact, as of today (June 2017), Buffett’s company, Berkshire Hathaway, has 93 BILLION dollars in cash equivalents that he is waiting for the right opportunity to invest. It is not that Mister Buffett lacks opportunities for investment, he probably gets pitched on a dozen different companies every day, rather, it is that Mr. Buffett understands that you need to wait for the the right opportunities to come along. As he likes to say, “You don’t need to swing at every pitch.”
It is not only important to “swing” at the right pitches, but you also have to be confident enough to make your swing and walk off the field. Controlling your downside risk this way means that you are not chasing trends by going in and out of the market on a fool’s errand, it will cost your dearly. It’s a death of a thousand papercuts. Trading commissions and banking fees will eat into the profits of any day trade, it’s banks and exchanges bread and butter, and there is no way around them. In contrast, long term investors only pay fees on two trades, their initial buy and their final sell.
Another important place to control downside risk is on strong market swings (up or down). If you are in crypto, by definition you have a strong stomach for loss,. Last week (June 21st) a flash crash on GDAX brought Ether down 96% before it rebounded. Keep in mind that on Wall Street, a 6% down market is news worthy material. So yes, you have to be able to manage with your expectations, but you also have to have rules to keep you safe. These rules should detail your upswing and downswing final liquidation criteria. Whatever they are I advise you to put them in writing: under what circumstance will you liquidate a losing positions or winning positions? When is “enough,” enough? You have to be goal oriented from the outset if you intend to be around even a few months from now.
Let’s be clear, you will have wins and you will have losses, but the important thing is that your losses approach the expected mean for the investment you are making. For example, one of the big mistakes that some novice traders make is that when they see their initial investment rise, they throw their money (loss) management strategy out the window, and pile onto their positions. No position that you hold should be able to wipe you out if it does not go your way. Yesterday I read an article on reddit about a man who claims to have taken a mortgage out on his paid off house to buy 325,000 dollars worth of Bitcoin. Now this happened in May, so given the current market the man is up considerably; but an ill considered trade is still ill considered, even if it pays off. Investing is a numbers game, if you go crazy and make money, that does not mean that you should go crazy again and gamble your life savings because the math suggests that over the long term, you will be wiped out, and crypto investing is a long term game.
Back to losses. It is fine to lose some money some of the time. The market is volatile and you should not expect your investment to always be in the black. We are not in it to make it the first week, or even the first year, we have a five year investment window and our number one job is to NOT MESS WITH THE TRADE. The only exception to this should be profit taking and killing the trade according to the rules you wrote down when you opened the trade. It is okay to build you position incrementally at first, butt once you are at your target level, that should be it for you. Our school of investing works on a “set it and forget it” principle, barring any fundamental shifts.
These are only some of the ways in which I encourage you to control your downside risk. The risks are both psychological and market born. The worse of them are a mix of both, and it is best to consider what they are and come up with a plan prior to making your first investment, then it is up to you to follow through with the plan. If you execute this plan faithfully, you will likely be around to trade another day, regardless of a single investments outcome.