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I recently learned that Van Tharp, one of the world’s leading trading coaches, had passed away.
Tharp gained notoriety in the trading world through his interview in Jack Schwager’s classic book, Market Wizards: Interviews With Top Traders.
And through the Van Tharp Institute, he trained thousands of traders throughout the world over four decades. I took several of his courses myself. His work influenced my thinking greatly.
As it turns out, Tharp was also associated with The Oxford Club in its early days. He even wrote a book with The Oxford Club’s then-Investment Director Steve Sjuggerud.
And you can see the lasting influence of Tharp’s thinking today in one of The Oxford Club’s Pillars of Wealth: knowing your exit strategy and sticking to it.
From Tharp, I learned that the “biggest secret” to successful trading is your psychology. He taught traders about “cognitive biases” long before they became fashionable.
In addition, Tharp taught courses in money management – the most underrated skill in successful trading.
Yet it’s a discipline that applies to all types of markets, all the time.
And in today’s speculative environment, I see many retail investors ignore money management at their peril.
Tharp’s Money Management Model
Let’s unpack what “money management” means and why it matters.
Most investors focus on “what to buy.”
Yet Tharp argued that what you buy accounts for just 10% of your trading success.
Far more important – Tharp put it at 30% – was your decision when to exit a trade. The most critical factor in trading is how much you invest in an idea – a concept he called money management, or “position sizing.”
According to Tharp, position sizing accounts for 60% of your trading success.
Schwager’s interviews with the world’s top traders in Market Wizards confirmed this.
When Schwager asked traders what the most crucial thing in their trading was, they always said the same thing: “bet size.”
And this understanding made them surprisingly conservative.
As market wizard Larry Hite observed…
Never risk more than 1% of total equity on any trade. By only risking 1%, I am indifferent to any individual trade. Keeping your risk small and constant is absolutely critical.
This kind of discipline is far easier said than done.
It’s easy to get wrapped up in your no-brainer investment thesis and bet too big on any single position.
I have made that mistake many times myself.
The Downfall of Meme Stock Traders
Today’s meme stock traders are a classic example of novice traders who don’t understand the importance of bet size.
Because it’s the lack of a coherent position-sizing strategy that will guarantee the demise of meme stock investors.
I’ve seen hundreds of postings on chat boards of traders betting all their money on AMC Entertainment (NYSE: AMC) or GameStop (NYSE: GME) “going to the moon.”
As sure as day follows night, these investors will have their heads handed to them.
In these videos, I focus on the weak fundamentals of each stock. Take this example…
You are a self-proclaimed “ape.” And you believe that AMC is the opportunity of the century.
You have $50,000 in your brokerage account.
AMC is such a good idea that you decide to bet all of your money on it…
Two things could happen:
- You hold on through the ups and downs, and you make 5X your money. You are convinced that you are a genius.
- Something “unexpected” happens and you lose all your money.
Here’s a quick quiz:
Which of the outcomes above is worse?
About 99% of people will say losing your money is worse.
Here’s why that’s wrong.
If you lose all your money the first time around, you lose only $50,000.
But if you win, here’s what happens…
You think you’re a genius… you mortgage your house… your relatives give you their retirement money to manage… you make another big bet… you invest all your money in a single idea… and then that company goes belly up.
In the end, you end up losing $250,000 (after all, you made 5X your money the first time!), your mortgage and your family’s retirement money as well.
This is precisely the fate that awaits investors in meme stocks like AMC or GameStop.
(This is also literally the entire business model of MicroStrategy Inc. except that it invests exclusively in Bitcoin.)
How to Stay in the Trading Game – and Become a Successful Trader
So here are some rules of thumb for trading, as taught by Tharp.
- Always set your exit price before you enter a trade.
- Use that exit price to calculate the maximum you are willing to lose on that trade – and size your position accordingly.
- As a rule of thumb, never risk more than 1% on any one trade.
These rules will allow you to be “wrong” 10 times in a row and lose only 10% of your portfolio.
Remember, successful trading is less about “being right” than making sure that you stay in the game long enough to win.
And we have Van Tharp to thank for spreading that eternal market wisdom.
Click here to watch Nicholas’ latest video update.