Towel Toss

“The elements of good trading are 1) cutting losses, 2) cutting losses and 3) cutting losses. If you can follow these three rules you may have a chance.” – Ed Seykota

Admitting defeat sucks. It’s one of the hardest things for investors to do. But knowing when to be disciplined enough to toss in the towel can also be one of the greatest advantages an investor can have. We’ve spoken at length before about the fact that predicting the future in markets is impossible. Anyone who actually claims they can is just straight up lying. Sure you can make educated assumptions about how certain things will unfold (ie the people who shorted housing and credit bubble in 2008), and you can make careful and calculated bets according to those assumptions which are hopefully constructed in a way that if your assumptions are wrong you lose a little but if they are right, you gain a lot.

But to say that anyone “predicted the future” is downright preposterous. This is why I constantly (ad nauseum) stress the importance of focusing on the only thing we as investors actually have control over, and that is protecting our downside.

Downside protection works in various ways and it differs vastly based on your investment approach. At the two far ends of the spectrum, when it comes to investing styles, are fundamental investors versus technical investors, or value investors versus momentum investors. These two camps often hold fiercely polarizing opinions on how investing works and many follow their school of thought like religion or political affiliation, which often times leads to some very entertaining debates, particularly in online forums and social media.

Value investors follow the Warren Buffett model, believing that assets should only be purchased when there is a clear discount to intrinsic value. They then to buy assets on the cheap during market dislocations when investor psychology gets distorted (when there is “blood in the streets”) and hold these assets until true fair value is realized, reaping a tidy profit.

Momentum investors, on the other hand, tend to be more trading-oriented and rely heavily on technical analyst and charts to dictate their trading decisions. They staunchly believe that past trading activity such as price movements and volume are not random but rather accurately effect all the available information in the market (efficient market theory) providing key indicators and patterns for future price action.

There are also many investors who have crossed over or converted from one style to the other (most notably is Jack Schwager, best selling author of the Market Wizards series who started his career as a fundamental analyst but quickly converted to being a true believer for technical analysis). And there are a very small minority of legends who are able to trade multiple portfolios some trading fundamentally and some technically. This is obviously extremely difficult to pull off as it’s hard enough to master one strategy correctly, let alone BOTH.

The investment processes of both styles are markedly different. On the fundamental side, much analysis and conviction building takes places well ahead of entering a trade. A floor or intrinsic valuation is calculated and fundamental investors wait patiently until they can get into the trade at the right price. As the trade progresses, fundamental investors are constantly challenging their assumptions, tweaking their models and trying to strengthen their conviction in the position until the fundamentals get reflected in the actual price of the security.

Technicians are far more trading oriented in their investing. They usually analyze charts, price action and volume to determine if they should jump into a trade and ride the momentum of a trend. They often times buy high and sell higher, hoping to only catch the meat of the trend as opposed to picking the bottom. Many momentum traders are glued to their screens watching price movements tick by tick and their general outlook is more short term oriented than value investors.

When it comes to managing risk, the two styles are vastly different as well. On the fundamental side, there is usually a catalyst such as an earnings event that these investors wait for that will allow their assumptions to materialize into the price of the asset. When there are changes to their assumptions then fundamental investors must quickly analyze the effect it will have on their target price and react accordingly. This is why we often see violent moves after an earnings release when a company “misses” which changes the underlying assumptions and targets of the fundamental analyst.

On the technical side, investors are much less emotional about risk. Most technical/momentum traders have a strict rules-based process that requires much discipline when executing. Momentum traders often use what is called a trailing stop, which is a price point at a certain percentage below where the current price is that when breached, they swiftly exit the position, without any analysis or emotion involved. Another technical trigger level many traders use is the moving average. Legendary swing trader Paul Tudor Jones has gone on record saying that anytime one of his positions falls below the 200-day moving average, he cuts it without thinking twice.

As you can see, there are no hard and fast rules for risk management. It highly depends on your trading style which is usually formed based on your personality. Investing is much more of an art than a science and over time and after many painful experiences of losing money, seasoned investors are able to introspectively realize their own faults and flaws and put robust systems in place to ensure that their egos do not get in the way of their PNL.

Admitting defeat is one of the hardest things in life, let alone investing. We all want to be right and we all, to a certain degree, have an ego that hates getting checked. The most important thing to do after taking a loss on a position is to walk away with a lesson learned. How can you ensure that this will not happen again in the future? One of the most important rules I’ve set for myself is that if I am at all uncomfortable with the trade (when the conviction becomes hope) I simply get out. What are some of the risk management rules you’ve put in place for yourself?