Risk Aversion Trumps Potential Profits!

I frequently hear asset management people tell people to hold onto stocks that are falling with the justification that eventually, they just have to turn around, or that they have fallen so far, they must have hit bottom. They reason that prices must move higher, and investors should therefore remain in them so that they don't lose out on the opportunity when stocks eventually move higher. I disagree with this philosophy for various reasons:

1. Opportunity Loss -- Every dollar that is invested in a losing stock/trade is a dollar that can't be used in a winning stock or trade. If that money is locked up in a bad trade, there are a myriad of opportunities missed that might have made money instead! One opportunity that is lost on a falling stock is the opportunity to short it instead. Even if -- like me -- you don't short stocks, you could profit from buying an ETF that does short that market sector! You could be making money from the ill sentiment toward that stock, instead of losing it. Or you could at least stop the loss by hedging with an inverse ETF in the same sector. Perhaps the greatest opportunity missed with this philosophy is the opportunity to have purchased that same stock or ETF at a much lower price. Taking a small, early loss is the only way to avoid this opportunity loss.
   
2. Clear Head -- When you exit a bad trade, your analytical skills improve immediately because you have cleared your head and can see the markets with a more objective perspective. It is amazing how releasing our minds from the emotion of a bad trade can help us to more clearly recognize the good ones.
   
3. Irrational Markets -- There is a saying (don't know who to attribute it to) that the financial markets can remain irrational longer than you have money to wait out that irrationality. This is true! You'll go bankrupt waiting for that "inevitable" turnaround that you just knew would eventually come. Even if that turnaround does come one day, there is a good chance you'll never see it because you'll lose your money waiting for it. It also seems to come just when we have been pushed out of the market after we just couldn't stand any more loss.
   One of my favorite thoughts from Phantom of the Pits is that we must recognize the blessing of a small loss. He also says that the trader who loses least, wins most.
   
4. The "Falling Knife" -- This idea comes from the very potent image that if you try to catch (or in this case, hold onto) a falling knife, you will get very bloody and experience severe physical trauma. The same concept is also true of our finances. Trying to catch a falling stock also bloodies the financial waters of our lives just as surely as catching a physical knife blade does. These financial "gurus" who suggest "holding on" to losing investments always reason that because prices have fallen substantially, they must therefore begin to rise now. No, they don't! Prices that are down can go even lower. Much lower! Momentum is to the downside! Stocks can go to zero! Don't try to catch a falling knife! Take your losses early, and you'll not only sleep better at night, but you'll also be able to keep a clear head (#2 above) to select other investments and get back into the market to make money instead.
5. Fox in the Hen-House -- Many of these supposed investment advisers and experts are in a losing market position themselves. It is true that "misery loves company". Many of these people (or their clients) are losing money on the same stocks they are recommending to others, and therefore they are hoping that by suggesting that other people buy them also, their own (or their clients') loses will stop and the stocks they recommend will start to move higher again, thus rescuing them from their own misery and losses. Corporate executives are notorious for recommending their stocks even while they are selling those same stocks themselves. These people have a gross conflict of interest, so all their comments should be taken with a grain of salt -- better yet, a pound or two of salt. This is also true for many investment advisers.
   

I would rather exit a bad trade quickly (Phantom's Rule #1), and buy that stock back again later at a much better price when the bottom has truly formed and when my thinking is clear. Thus, my purchase price is better and my return on investment is also improved versus someone that buys and holds regardless of market turmoil.

Miss First 20% and Last 20% of Trend
One investment tip that I have heard attributed to the Rothschilds (although I don't know if this is true) is that they don't try to catch the first 20% or the last 20% of a stock's rise. If someone holds onto a bad trade, they stand to risk all or most of the rise, not just miss the first or last 20%. I have found that my trading methodology allows me to accomplish this -- getting in at the early stages of a new trend, and getting out just as the momentum is starting to wane. Sometimes I'm wrong, but more often than not, I'm successful, and my successful trades are far more profitable than my bad ones. Learning strong technical analysis skills helps tremendously to reduce the risk and raise profits.

Best Book on Risk Vs. Profits
My philosophy on focusing on reducing risk instead of on profits was influenced heavily by Phantom of the Pits in his book, "Phantom's Gift". It's the best book on trading that I've read, and what makes it even better is that it is available free. That's not just a bargain. From the perspective of return on investment (ROI), it's value is therefore literally infinite! My only real investment is the time to read it and the effort to change my behavior. I can't make a better investment than that!