I believe the most overlooked discipline to the stock market is the importance and application of risk management. I mean, most people don’t even know what that ‘really’ means, yet they own stocks. People tend to think that buying a stock must mean it has to go up from there and they’ve made the absolute correct investment decision. Doing this is exactly the same as saying you know what the weather is going to do tomorrow, because you looked at a doppler radar. Sure, you can get a good idea about what may happen tomorrow, but even the meteorologists get it wrong sometimes. Purchasing a stock without acknowledging you could be wrong (and know where that point is) is exactly the same as the meteorologist who calls for sun, then it rains, yet he still says it’s sunny. It’s irresponsible and a poor investment strategy.
So, what is risk management? Investopedia describes it as:
“Simply put, risk management is a two-step process – determining what risks exist in an investment and then handling those risks in a way best-suited to your investment objectives.”
But, in my own words a better and simpler way of saying this is: know the point in which your investment is wrong. If you were a meteorologist and you called for rain, yet it was sunny, you would know the point in which you prediction was wrong (when you wake up the next day and it’s sunny, not raining).
The point you pick when purchasing a stock for the ‘infliction’ point (point where you are wrong) is relative to your personality, strategy, time frame, etc. So, unfortunately I cannot tell you a one size fits all formula for this discipline. However, to not know (or have) a point is to not have a robust enough strategy to be competitive in the market place in the long run, I can guarantee you, you will go out of business.
An real example from my trading of the importance of risk management can be seen in a recent trade in $RALY of mine.
I bought this stock on 4/23/15 in anticipation of a breakout higher. So, logically, I would know when I was wrong in this trade when the stock failed to breakout higher. But where is this point? Right below the recent candle’s low (4/23).
Once the risk management level (also called stop loss or infliction point) is determined, the trade can be placed. Unfortunately, this stock did not breakout higher like I had hoped, but luckily I had a plan for this type of event – risk management – and when the infliction point was hit, I sold and moved out of the way as the reason why I was ‘in’ the stock was no longer valid. In this particular case, if I had held onto the stock, it would have cost me a lot more than my measly 3.5% loss, it would have cost me a whopping 14.5% loss and that’s a lot. Imagine if you had three trades in a row where you didn’t have a stop loss and each one you lost 10+%, you would be out of business in no time.
I cannot stress the importance of knowing the point in which your purchase is wrong. If you want to be in the business, you have to know the limits. This is not a get rich quick business, it is a slow grind, through careful analysis of risk and potential. If you want a roller coaster of emotions in your job, you’re better off elsewhere, because if emotions or careless decisions ever get a hold of you in this business, you won’t be around much longer.