This particular article isn’t going to go all Pollyanna on long-term equity investments as the way to financial success. The fact is, no one knows what the market will do in the future. Maybe it will go up over the long term. Maybe it won’t. But even if you’re not in your 20s, that fear of uncertainty from what happened in 2008 may still be there. It reminds me of a story I read about Richard Dennis, legendary futures trader, talking about rookie traders. He said that new traders/investors are like baby ducks. When a baby duck hatches, it thinks the first thing it sees is its mother. If the first thing it sees is a battleship, the duckling will follow that battleship around forever. Traders can be the same way. The first big market event they experience—whether it’s a market crash and a big loss or an unending rally and a big profit—they think that’s the way the market always works. And that kind of baby duck thinking can be lethal to a trading account or investment portfolio.
If you started investing during 2003 through 2007 when the S&P 500 rose over 50%, you might have thought that markets go up consistently and you didn’t really have to worry about the downside risk. Then when the market crashed in 2008, that shock not only cost you money—it imprinted on you the fear that another crash might happen at any moment.
Since the market crashed in 2008, the S&P 500 has risen pretty consistently. At the time of this writing, it’s basically at the level it was in the summer of 2008. The market crashed and bounced back. So now, you can add to the fear of uncertainty the regret of not participating in the rally, plus the hope that if the market does drop back down, you’ll step in and buy. But then, of course, the market might keep on crashing. You just never know.
Tricks of the Trade
So, how do you get past all this? If you don’t try to get some return on your money—whether through equity investments, bonds, or a bank account—that can also be a recipe for financial woe in the long run. What you need are some specific approaches to investing that will help you move forward. I can’t promise you’ll make money, or that you’ll never be scared. But you will feel much more in control. Here are a few ideas.
Risk and Capital Management
Risk and capital management should come first and foremost, but they’re consistently missing from investment strategies. Most investors think only about the potential profits, not the possible losses. But when those losses do occur, they can be bigger and happen faster than anticipated. You can read whole books devoted to risk management, but very simply, it just means factoring in how much loss a particular position might incur if the stock or market makes a big move in the opposite way you think it will. If you think a stock will go higher, and you put on a long position or a bullish options strategy, what happens if the stock drops 10%? 20%? 30? What if it goes to zero? Now, this isn’t being pessimistic, and it doesn’t mean that you shouldn’t do the trade. It just means you should be prepared for what might happen in a worst-case scenario. Using the tools on the thinkorswim® from TD Ameritrade desktop and mobile apps, you can simulate those types of price changes and see how big the loss might be on the position. If you look at the maximum possible loss and it’s too big for you, you can reduce the size of the position (i.e., 100 shares instead of 200) or add some protection, such as a stop-loss order or a hedge using options. Or reduce the size and add the protection. The point is that you’re taking positive steps to help limit the potential loss of your position, and that’s the heart of risk management.
Related to that is capital management, which is making sure that if that worst-case scenario happened to all your positions, you would still have enough money left to continue to trade. As a place to start, I’d suggest making sure that if every stock or option position you had experienced its maximum loss, you’d still only be risking 20% of your total trading or investment capital. Hey, losses happen to even the sharpest traders. The difference between them and the newbies is that professional traders always make sure they have capital to trade with despite losses. Risking 20% (or less if you’re more risk-averse) leaves you with 80% of your capital to continue trading after a string of losses.
Sure, “hedge” has become something of a four-letter word in public opinion, given the stories we’ve all heard about hedge funds. But hedging is a key to risk management, and it just means you employ certain trading strategies to try to reduce potential losses to a level that you can handle. Hedges for stocks and even whole portfolios can be as simple as long puts, or more complex strategies such as vertical spreads, calendar spreads, and even futures. The more types of hedging strategies you understand, the better you can employ them under different market scenarios and on different positions. Volatility levels, your time frame, and the amount of hedge you think you need versus how much a hedge might cost you will affect the type of strategy you use. You need to remain flexible there isn’t one single hedging strategy that you can use in every scenario. There are different ways to learn about hedges, including live classes. Think of it as another form of preparation. The more you learn, the better prepared you’ll likely be for the next financial meltdown.
What does being nimble have to do with investments and trading? It means you’re not just a buy-and-hold investor who is willing to get slugged around by turbulent markets and who is just waiting for his stocks to go up eventually. Stocks and markets go up, down, and sideways. You can take advantage of that and get a potentially better return on your money by using strategies that are designed to be profitable in those rising, falling, or stagnant markets. For example, if you think that the market might not move up or down much for a certain amount of time, plain long stock positions might not work. A positive time decay, defined-risk option position might work out better. If you think that the market might sell off and that volatility might go higher, long stocks might not do so well. Instead, option spread strategies designed to profit if the market goes lower and volatility goes higher might be a better choice. Don’t be a one-trick trader. Use the strategy for what you think a particular stock or the market overall will do.
These suggestions are all related and have a couple central themes: prepare and learn. In fact, by learning, you’re helping yourself become more prepared. That’s going to make you more confident and smarter about the investment choices you make. Don’t let a single bad investment experience scare you out of the market forever. Overcome the fear, and you’re a step closer to becoming a more confident and prepared trader.