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Tuesday, June 2, 2009

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Trade with the Money You can Afford to Lose: Another Myth in Stock Trading


In the series of myths or false beliefs a trader builds about stock trading, this is something very foundational to a stock trader. By working at the capital used for trading this belief acts like a huge blockade even before the marathon is started. After making some initial losses some traders develop this theory on their own while some advocate this to other newbie traders. Novice traders and intelligent people too get trapped in this theory. They do not just start with the money they can afford to lose but also continue to trade so all along.

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When I was first introduced to the stock market I was enthusiastic to know more details about entering the stock markets. “How much money to start with?” is one of the first questions any traders will ask himself or other experienced traders. They often do not realize that there are two sides to this theory of trading with the money you can afford to lose.

Start with the Money You can Afford to Lose

Several people start trading stocks with enthusiasm. It is those people who started with money they cannot afford to lose but end up losing big quantity of it, develop this belief. They make this a principle for their stock trading. You know what, they stop their trading experience at this point only.

I too was told on the first day when I attended a seminar about investing, risk management etc. At the end of the session some people asked questions. I waited to listen to those answers while others started leaving. As I was more interested than others I had stayed to become more certain of this business. Then the speaker (Anand Agarwal from Hyderabad), discussed various things. He was more cautious about giving information thinking that might harm our career or capital with new ventures.

Then there was another person who had little experience and started telling this theory when some other person asked about how to start. This person plainly told, “Start with the money you can afford to lose”. In other words start with that capital that you will not bother losing, or you are ready to lose right now or it does not make you sad at all when you lose it. Even the speaker appreciated it saying it was an important principle. Little did I know at that time that these people do little trading but more talking.

This theory simply implies that you should use money for trading stocks, which can be very small for your eye. Obviously nobody can afford to lose even 10% of their monthly salary. But some people are ready to lose a month’s salary but it is nevertheless very unaffordable to them. They are ready because they are willing to take risk and responsibility rather than just playing it safe.

Several experts advocate this theory. It also makes sense to start with little money or money you can afford to lose because it will be very bad to lose the capital in the first trade itself. It will be a disaster and you may not get over it easily as first impressions are often the lasting impressions. But the problem is that these experts also advocate to continue to trade with the money you can afford to lose. These experts are so scared of giving right advices because it is risky. But there are few people who take that risk and always add disclaimers when giving such suggestions.

My Understanding of This Myth

My understanding of this theory developed with my own thoughts as I started trading stocks. At first I started with the money I cannot afford to lose. Because if I were to afford to lose, there is no money whatsoever. I couldn’t even think of losing a hundred rupees just like that without gaining anything from that experience. I started directly with thousands because that is what makes sense and affects my learning about trading.

As I started I had already been thinking about the profit amount on the first bet if it were 2%, 5% or 10%. The profit amounts looked small with very low capital I am willing to lose. But with the amount I had actually bet, these percentage profits are showing an amount that is comparable to my daily earnings at the job.

Once I had my first few trades, I started learning more about this theory. I realized that this is a false belief and makes a trader get stuck in the beginning never to progress. I asked some intelligent questions to myself and concluded interesting answers.

Why should I trade with the money I can afford to lose?
Because when a trade results in a loss, I wouldn’t be badly affected. I wouldn’t be depressed because I am anyway giving away that money. That money doesn’t matter to me at all. Let me lose it just like that!

How much money can I afford to lose?
Initially it was very small amount. So small that it did not make sense to spend time for trading with that amount. The profit or loss is so negligible, even if the stock doubled or lost 50% percent, that I would not care for it. Though I raised the amount that I can afford to lose over time, still any result as a profit or loss on that amount is negligible. If I were to determine the amount of money that I can lose, it was always something that I wouldn’t care of its consequences as well. And may not even bother spending time on using it.

What will I gain with that money used for trading?
The intention is to learn to trade well and also to learn from mistakes when we are just starting. Even as we continue we still need to learn. But with the money I can lose, the profit or gain on that amount is so small that I couldn’t find any significance in the result. Whether it was a good trade or a bad trade, it simply didn’t have enough weight to affect my beliefs and learning about trading.

As I neglect that money I will someday lose all of it in a single stock. I will let it go because it wouldn’t make a difference. As it does not affect I will not learn any lesson at all.

Why This Theory is Very Bad and What is the Right Theory?

I studied these answers carefully and concluded that if I trade with lesser money I would not learn anything. The intention to start with is not just to lose in the first trade. That loss itself is not certain. But if I continue so, I would not be able pay enough attention and thinking on its results. Simply because these numbers are so small that does not affect my decision making process. I will even start neglecting that money and end up losing all of it. That does not anyway make a difference. But the big loss now is that I stopped without any meaningful reason.

This happens for many people. And they go back to their work never looking back at trading. They lose interest and do not realize that it is all due to this false theory.

The other side of this is that you should start and continue to trade with the money you cannot afford to lose. Many people would say, “You should never trade with the money you cannot afford to lose”. Here I am saying complete opposite of that. I have very strong reasons that I learned as my first lessons in trading stocks.

If you trade with the money you cannot afford to lose then you will pay attention to that activity. You will not lose sight of that even when you are busy with your day job, or any other activity. You will still make time out of your busy life because now you feel that money is important and also any profit or loss from it.

You will be psychologically and financially affected significantly when you make a gain or loss when you complete a trade. The weight of the loss or gain is significant enough to let you think about it several times and even note down the details of this trade. That also makes you learn a lesson from it whose weightage is dependant upon how much you gained or lost.

It is Important to Learn on Your Own

The significant things that can make a difference to your life are what make you learn on your own. Things are different when you are learning in a school or college. Even there, if you miss a class you wouldn’t bother much but what if you miss an exam? When you realize that a class you didn’t attend would have helped write an answer, you will realize the importance of that. The studies always take a significant weightage for a student’s life naturally whether there is any money directly involved or not. Students are very clear about the long term effects and their significance to their life.

But the stock market learnings are not similar. Actually any study that you want to make on your own and mainly the lessons from entrepreneurial journey are what very difficult to focus on. We need some strong reason to focus on those activities and learn a lesson with every action and its result. An entrepreneur can afford to lose it all but cannot afford to lose the lessons.

The stock trading involves a lot of learning and if you are not willing to learn you can never expect to make it big here. It is better that you give up now and spend time on other things that are important to you.

But if you are a person who has a long learning curve and is always willing to learn, improve then you should reverse this theory in your mind. Remember if you are ready to lose, you will definitely lose. What is important is not the loss but the lesson that tells how to avoid it next time. Unless the consequences are significant enough, you will never learn anything. The events should have a lasting impact and you should not pay, to learn the same thing again, in the form of repeated losses.

So always trade with the money that you cannot afford to lose. Then you will certainly make sure that you will not lose it.

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