There are two investment rules that are popularly attributed to Warren Buffett, but which I think actually precede him. The two rules are:
- Rule #1 – Don’t Lose Money!
- Rule #2 – Don’t Forget Rule #1.
Stock Trading Rules To Keep In Mind When Playing The Market
No doubt you’ve seen these statements before and they’re a bit overdone, but you get the picture. These golden rules were meant to remind us of the effect of investment losses. Here’s what I mean: these rules are vitally important when you consider that if you lose 50% of your investment, you need to secure a subsequent 100% profit merely to break even. If your favorite stock holding loses 90% of its value — and some big names did a few short years ago — then you need to turn your position into a ten-bagger in order to make you whole again.
It is better not to lose money in the first place than to try and make it back, as you can see here:
| Loss Sustained | 10% | 20% | 50% | 75% | 90% | 99% |
|---|---|---|---|---|---|---|
| Recovery Required | 11% | 25% | 100% | 300% | 900% | 9900% |
How To Avoid Losing Money in the Stock Market
A while back, we boldly stated that most investors don’t make money in the stock market, and provided the reasons why. It’s best to stick with mutual funds and avoid trading the market unless you’ve got sufficient experience [although if you insist on being an active trader, then you may want to try paper trading first].
Talk is cheap, and stock speculation is expensive if you get it wrong. So how can we actually go about not losing money in the stock market? Here are some ideas:
- Apply stop orders to your stock positions in order to limit your losses or (even better) to lock in your profits.
- Use a small position size initially. Don’t bet the farm by investing too much too soon until you are sure that your stock pick is heading in the right direction.
- Diversify so that no single adverse price gap or company bankruptcy can wipe you out.
- Keep your trading and investment costs low by choosing a discount stock broker or an investment fund with low initial charges and a low Total Expense Ratio (TER).
- Invest via a tax-efficient investment account.
- Test your trading and stock picking abilities first on a virtual stock trading platform where you’re not risking your money.
Play the Markets Like You Play Golf
I’m no golfer, but I understand that the best golfers are the ones who make the fewest mistakes rather than the ones who hit the biggest shots. Play defensively. Take care of the downside and let the upside take care of itself.
Play the Markets Like You Play Poker
Professional poker players do not see themselves as gamblers. They know when it is safe to take big swings (like the golfers) by betting large, and when it is better to play conservatively so as to merely stay in the game. Their small but effective ‘edge’ over the other players should pay off over time, providing they don’t go bust along the way.
Play the Markets The Way A Casino Is Run
Don’t put yourself in the shoes of the gambler; take on the position of the House. Unlike the poker players, the casino owners have a guaranteed edge that will definitely pay off over time because the cards are metaphorically –- if not actually -– stacked in their favor; the roulette wheel (in America at least) has an extra pocket labeled “00” that gives a probabilistic edge. Casinos don’t make wild bets, they let their punters do that, and they merely wait for their edge to pay off. If you have an investment edge, then you should wait patiently for it to pay off; if you don’t have an edge, then no number of “all or nothing” bets will save you.
Don’t Invest What You Can Afford To Lose!
There is a popular saying that you should invest in the stock market only what you can afford to lose. There’s nothing wrong with this sound advice until you consider the following salutary lesson:
A friend of mine was once a high-flying IT consultant with a big salary, flashy car, and all the other trappings of a successful career. He could truly afford to lose a lot of money… so he did! It was only when he quit the rat race to write, publish and trade stocks full-time that he learned to actually make money in the markets; or at least to not lose too much of it. He could no longer afford to lose money… so he didn’t.
Okay, so this wasn’t a friend of mine. It was me!
Contributing Writer: Tony Loton is prolific writer, private stock trader, and author of the books Stop Orders and Position Trading (Second Edition).
Copyright © 2011 The Digerati Life. All Rights Reserved.
{ 6 comments… read them below or add one }
It’s all about playing defensively. The touchdown passes are what they show on the highlight reels. But it’s those tough hold-the-line defensive plays that set you up for the touchdown passes. DE-fense! DE-fense! DE-fense!
What “DE-fense” translates into in the real world is not investing heavily in stocks at times when stocks are priced to crash. Warren Buffett holds what he buys. The Buy-and-Holders have that in common with him. But Buffett only buys when the value proposition is strong. That’s the point that the Buy-and-Holders are missing. You need to buy at the right price and then hold.
Rob
Hi Tony,
These are great tips. I’ve always thought that it’s important to remember that this is really like embarking on any other business. You have to evaluate the risks, make your plays accordingly and above all, don’t be so greedy that you lose all perspective (and all your money). As Cramer says, Pigs get Slaughtered.
If you approach the market sensibly, you can do well. Thanks for giving us some guidelines for doing so.
Danielle
When you trade you learn about yourself. The stock market can be an expensive place to learn about yourself.
I would love to add one more thing: It is often wise to go against the market :).
Thanks for your comments, folks 🙂
Tony Loton (article author)
I do agree that trading is a game of probabilities, the hardest part is to accept that you made the wrong pick and get out. Most new traders don’t trade out of a losing trade until it’s too late. Huge mistake because until they can comfortably accept a loss, they won’t make any money.