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Monday, June 8, 2009

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Never Make or Take a Loss: You Should not get Trapped with This Belief


When I took the first loss from the stock market one of my friend with whom I discuss stock trading, had given me this principle. The loss though first, was the biggest loss at that time. He told me that the first rule of Warren Buffet’s investing is to never to take a loss and the second rule is never to forget the first rule. It sounded good at that time until I realized how much blood it will take if I were to stick to this.

never make or take a loss, don't get trapped with this beliefImage Source

I was initially depressed about the loss because I had taken it out of a logical decision and not a practical decision. The logic does not work well all the time in stock trading. I did not know that at that time and wanted to give it a try. The stock market recovered immediately and I too would have recovered half of the losses in that same week. The loss came as a sudden surprise from Monday to Tuesday.

At first having learned these two rules from a friend and that too to be of a veteran investor, I got trapped for this belief. I thought it sounds good. It seems too appropriate. If had followed the rule 1, I would not have made such a big loss. If I had forgotten the rule 1, the rule 2 would have reminded me. It was a combination of intelligence and principle. But little did I know at that time that it was a ridiculous rule!

What is All This About?

Let me give an insight into what happens when you get trapped with this belief. Those who cannot take or make a loss from their stock trades, have to end up holding the stock whenever it falls below their buy price.

We are not ideal to always make a right decision to buy the stock at its support point so that it always bounces back from there and we do not see a loss. We are also not ideal traders who could avoid their first loss by buying at the support price from the beginning. And even if you do all that, still the support price itself can change over time and it may move just below your buy price.

So that means we are bound to see our stock going below the buy price. When that happens, it is giving a warning that the trend is going to be bad, that we have the best opportunity to cut our losses at minimum. I have seen that the biggest losses always start with this smallest loss where there was opportunity to cut it off.

There are two things that can happen from there on. The stock will bounce back and go make new highs. In this case you will be very happy if you held the stock following this belief to never take a loss. Of course you should have some rule to take profits at the highest point. That is not the topic of this post, so I will not talk much on that.

On the other hand the stock will continue going down in price. Each time it bounces a little bit it is giving another opportunity to close it. By following this belief to never take a loss, you will get trapped in a stock that keeps going down and down and down to the bottom of the ocean.

Imagine how it would be if you had this experience at any time in the last year. In a bull market these things do not happen and so you would appreciate every silly theory about stock trading. It is only a bear market that shatters all myths and exposes the true hidden secrets for trading successfully. These are also the same secrets that help you make the most in a bull market while others just get you along with the bull ride.

When you get trapped there are a lot of bad consequences that can happen in your life other than financial loss. There was an incident in India in the last year that the husband of a stock trader had decided to divorce her after she made a loss of about 30 lakhs in stocks. He did not want to take that burden when she was making losses. But he would have liked the profits though.

There are also a lot of stock traders who have committed suicide due to margin trading failures in January last year. I would heartrending to read their stories. In fact there are many real estate builders who have sold off their properties for cheapest prices and some have committed suicide because they have incurred huge losses in the stock market. These people are the cause for the fall in reality prices at the same time as the stock market is falling in the last year.

There can be more bad things that can happen if you don’t pull the trigger to cut losses when they are small. Apart from this problem there are other things that you should know to become a successful stock trader and never get into these traps.

Making a Loss is Not Your Choice

Contrary to what many people think making a loss is not same as taking a loss. The stock market’s behavior and its individual stocks’ behavior are not at all in control of any individual trader. As such you can never control whether you are going to make a loss. You can only consider the odds of it before starting any venture.

The stock market behavior is just like a random behavior though there is a pattern in it. It is actually a stochastic behavior. Only people who can understand the statistical nature of this behavior can assess the odds of a situation.

The fact of the matter is that you can control how many losses you may make out of how many attempts by following strong trading principles. But you can never control what will be the fate of a given trade at any point of time.

This is the reason that you can never choose to make a loss. That can happen without your knowing or intention. Then how can you think of rule 1 and then rule 2? You will get irritated about this theory if you really understood what I told so far.

Taking a Lesson By Taking a Loss

I realized that I had done a good thing by taking a loss at my first losing bet. I had only made little profits before that losing trade. Though the loss was big I had taken this loss as I analytically thought that the losses could increase if I didn’t take that.

The losses didn’t increase at that time. But by following this rule to cut loss early on, I had not only saved myself from later even bigger disasters but also learned a lot of wonderful lessons about stock trading.

You should note that by taking a loss early when it is small you are respecting the warning that the market is giving you. It will definitely knock your door when there is a new opportunity. It really happens just like this in stock trading. I had no choice but to accept this as reality.

You will not just cut loss by taking a loss early before it can become big. You will also learn powerful lessons by watching how the stock behaves afterwards and studying all your interaction with the stock since the idea of entering it started in your mind. This is a valuable lesson that is practical and cannot be substituted with any money or training.

A Loss is the Price You are Paying for Your Learning…

Note that every such lesson must be learnt by paying a price. The small losses are indeed the best price you are paying for a lesson. If you don’t do that you are most likely to close a trade by taking loss when it almost hit the bottom. It happens for almost everyone in this business. There is really no point in hanging around with a stock when it lost 95% of its value. Anyone can understand that it is ridiculous to expect a 100% or more turnaround from the same stock. Then the price you paid is too costly.

I did such mistakes again and again but I was glad that I did not do this atleast half of the time. That helped me learn lessons, avoid big losses and what more it also helped me take profits on opportunities that I would have missed if I had hanged around with the same losing stock.

It is Never Late to Learn Stock Trading Principles

Atleast it is not very late to learn this lesson and avoid this belief. You should not worry about taking a loss or making a loss. What you should worry about is its consequences. Assess the varieties of consequences and cut losses early on. Even if the stock were to rebound, it does not matter. You can go immediately for another rising stock that is just delayed.

Note that in the stock market different stocks move at different times. There are some called as laggards that are lazy and some as leaders that are too enthusiastic to be in front of the whole market showing the trend of the market. This helps you get over the small loss you had cut early on.

The right lesson is to learn that it is not in your control to make a loss. But you can take a loss and avoid further losses. You will also not lose another immediate opportunity by doing this. Most importantly taking a loss whether early or late, big or small, means that you are taking a lesson that is practical and unique for your style of trading!

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