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The Most Underrated Part of Trading Well
Yes yes, of course the key to long term successful trading is to be able to pick winning ideas – a task by the way that is much harder to achieve then it seems. But I think many traders miss the other key aspect to long term positive performance – not losing. Not losing is not the same thing as winning. Not losing is the art of avoiding bad ideas – which is a skill wholly separate yet no less important than the ability to find winning trades.
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Warren Buffett when asked what was his number one rule for investing said, “Don’t lose money.” When asked for number 2 he replied, “See rule number 1.” That philosophy served him well over the past twenty years as he was able to navigate financial crises much better than most investors. In 2000 and 2001 when the S&P was down by -20% each year, Buffett was only down by -3%. When equities rebounded, other investors needed to see a 40% jump before just getting to break even, Buffett on the other hand was profitable the very same year stocks turned positive. Therein lies the power of not losing.
Not losing should not be confused with not trading. After all of us can simply sit in cash all the time, but that means we will never see any returns. Risk assumption is the essence of trading and if you get involved with the financial markets you WILL lose money. The key however is to constantly evaluate and assess the quality of your risk.
To do that well, it helps to think like an insurance company. Insurance is the very definition of a risk business, but insurance companies go out of their way to minimize their risk as much as possible. How do they do that? A few ways.
First and foremost insurance companies rely on the law of large numbers and spread their bets as wide as possible. No life insurance company will write a life policy of 1 Billion dollars for one man, but they would all be happy to write 1 Billion dollars worth of policy for a million men.
Secondly, insurance companies do a lot of research before they underwrite you. They want to know if you smoke, if you ride motorcycle, if you bungee jump, if you ever had cancer – so on and so on. In short insurance companies are looking for a thousand reasons to say no so that they avoid an unnecessary loss. As traders we should follow the same formula. When looking at trades we are always focused on all the reasons to make them – all the reasons to say yes. By thinking like insurance underwriters we could become a lot more disciplined and selective in our approach and hopefully learn how to lose less – the most underrated part of trading well.