Tackling the question using the inversion method
Berkshire Hathaway vice chairman, Charlie Munger, when asked about how he coped with missing out on opportunities like Amazon and Google, famously explained that losing and missing are a part of trading and what really matters is – at the end of the day, you’ve won more than you’ve lost.
Today we’re going to take a look at another piece of wisdom from Charlie Munger, his belief that a problem is more easier to solve when it’s looked at in reverse. Munger stands by his assertion that inversion will help you solve problems and we’ll explore the method a little later.
But first –
The Reasons Why 90% of Traders Lose Money
Buy Breakouts and sell breakdowns.
Traders that are chasing the stock price around and acting impulsively from one moment to the next don’t have much of a plan other than to react to market fluctuations. If we know anything by now, it’s that sticking to a well crafted trading plan is one of the most important things any trader can do. Chasing highs and lows, runs completely counter to a well thought out and executed plan.
Cut losses short and let their winners run.
While this sounds great in theory, let’s do a full stop right there. It doesn’t work in practice. Drill this into your head – over the long run, this strategy will burn you and burn you bad.
Take bigger position sizes due to greed.
Oh how much money you could make if you put a little more in and the market performs how you really hope it will… stop now! If you have a solid trading plan, with well defined risk, follow your plan. If you don’t have such a plan, stop trading immediately and make one. If you’re in it for the long haul, you’ll have to be patient and not influenced by the greedy prospect of big gains.
Fear of reducing cost basis because they might be capping potential profit.
Remember what Charlie said about winning more than you lose over the long haul? It’s important because trading is a marathon not a sprint. Small gains over an extended period of time will ultimately top big gains over a short period.
So, Why Do So Many Traders Make These Mistakes?
In many cases, it’s because this is what was taught to them by investment education websites. These sites often tell you what they need in order to make themselves richer. By promising get rich quick schemes, the websites are not out to make you a better trader, rather to make them more money. Anyone who tells you to cut losses small and let your winners ride is either lying or has never traded before.
Now it’s time to get back to that word inversion which we used earlier.
Using Inversion to Craft a New Trading Strategy
The first step in fixing your problems by looking towards the end first, is to buy into weakness and sell into strength. The big reason to do this is because it’s the opposite of what most traders do.
If you’re worried about not knowing if a sell off is over, we have some bad news – you can’t know. The good news is, no one else will know either.
The next step is to book profits and to be patient with losing trades. With a high probability trading strategy, almost all losing trades will now become winners if you’re patient. When you cut your losses smaller, you’re going to squeeze out a lot of good trades but if you try to let your winners run, you’ll be very angry when they don’t perform as you expect them to.
The third step is to keep your position sizes small. This let’s you make decisions based on logic, not emotion. If the positions are too big, the regular fluctuations in the market will impact you disproportionately hard and lead you to make poor decisions based on emotions.
The fourth and final step is to reduce your cost basis. Only place trades with a defined profit strategy. These strategies might have a lower profit potential but they have a much higher success probability. If you’re buying naked options, you’re doing the exact opposite and hurting yourself. Over the long run, this lower profit but higher likelihood of success will earn you far more profits than the one big trade you might have won in your old system
Even the Best Lose from Time to Time so Be Patient and Follow Your Plan
Remember this every time you lose a trade and feel yourself on the verge of anger or frustration. Take a deep breath, remember the sage wisdom of brilliant minds, consult your trading plan, and keep a cool head. Patience in the short term will translate into success in the long term. You can do it if you train yourself properly and control your emotions.