Alpha Power Investing Newsletter

July 2, 2018

The Critical Importance of Strategy and Risk Control
 

There are many factors that can lead to investment success, or a lack thereof. Our experience suggests that perhaps the two key factors to investment success are a disciplined approach to investing and strong risk control.

A "disciplined approach" can best be thought of as a "strategy" or combination of strategies. While an investor does not necessarily have to adhere to a 100% mechanical system, the key point is that the more objective the decision-making process - and the less it is vulnerable to subjective decision-making based on fear and/or greed - the greater the likelihood of long-term success.

"Risk control" involves any step or combination of steps that an investor takes to minimize the size, length and impact of any single losing trade and/or series of trades. Which raises a key point. Investors by and large are loath to discuss losing trades, even though we all experience them. This is especially true of the really bad investments that one looks back on in retrospect and says, "What the heck was I thinking?" This is due in part to simple human nature and the need for affirmation.

It is also due to the fact that most of us have heard tell of enough supposedly "wildly successful" investors over the years that at least some part of us subliminally believes that there are investors out there who are so super successful that they almost never experience losing trades and are rarely even wrong about the markets. And who knows, maybe there are. But you can rest assured, even if there are such people, they are few and far between. The rest of us are left to deal with the reality of the markets.

Reality Isn't Always Pretty
A long time ago I knew a commodities broker from New Orleans named Mike. Whenever a new customer opened an account he would offer them his "guarantee". It went like this, "I guarantee you that you will experience losing trades." It was certainly not what most people wanted to hear. But the fact of the matter is that he did them a huge favor by properly setting realistic expectations, because in reality a properly managed losing trade (or losing period) is nothing more than a cost of doing business. As a result, getting upset about a losing trade is an exercise in futility. It's kind of like getting upset about your printer running out of ink. You knew it would happen eventually. But when it comes to losing trades, there is losing and then there is really losing. Interestingly, there is also "winning while you are losing". Please allow me to explain.

The Two Dangers with Losing Trades
One of the most important keys to long-term trading success is to keep all loses to a manageable (i.e., small) level. There are two dangers when it comes to losing trades.

  1. Financial Danger: First off one must understand that there is "losing", there is "losing big", and there is "losing catastrophically". If one expects a worst-case scenario of losing say 5% of their capital and then they lose 10%, that is a bad thing. However, the fact remains that they still have 90% of their investment capital and are still very much in the game. On the other hand, a person who loses 40% or more of his or her capital is in a very different place. So clearly - and granted, fairly obviously - smaller losses are better than bigger ones.
  2. Emotional Danger: In this instance, the phrase "emotional danger" is not about getting your feelings hurt. It refers instead to the potential for a bad investment today to affect your thinking regarding another investment tomorrow, or the next day, or somewhere down the road. Like the person who touches the hot stove and gets burned, an investor who suffers an "unexpected" and/or "large" loss may be hesitant to act the next time his or her investment methods tell them to. This can lead to a "domino effect" of second-guessing, uncertainty and the inability to successfully implement even a solid investment plan.

The Bottom Line
So, the bottom line is this, catastrophic losses are, well, simply catastrophic and leave you unable to continue, so clearly must be avoided completely. Losses that are larger (or which unfold more quickly) than investors are prepared to deal with emotionally (which by the way, for most people is less than what "you think you are prepared to deal with emotionally") can lead to emotional decision-making in the future which is almost guaranteed to cost you money.

The key then is to adopt a strategy in which you have confidence, which has risk controls built in to help mitigate the inevitable bumps in the road, and to do the occasionally hard emotional work of maintaining the discipline to follow your strategy.

To learn more about how Alpha's strategies control risk, please go to Strategies and Performance section of our website at www.alphaim.net to read the brochures and fact sheets. 
To read more about Alpha's strategies, please go to the Strategies and Performance page of our website at www.alphaim.net to read the brochures and fact sheets. 

Jay Kaeppel
Vice President and Director of Research
Alpha Investment Management, Inc.
877-229-9400
www.alphaim.net
info@alphaim.net

Alpha Investment Management, Inc. is a SEC registered investment advisor. Such registration does not imply a certain skill or training and no inference to the contrary should be made. The information and opinions expressed in this document are for informational purposes only. Any recommendation or opinion made in this document may not be suitable for all investors. The information contained herein does not constitute and should not be construed as investment advice, an offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

© 2018 Alpha Investment Management, Inc.

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