I never get sick.
So when I came back from a recent trip to New York and started experiencing the chills, aches and other discomforts of a spiraling virus, I resorted to my usual cure-all.
A cold plunge.
For those of you who aren’t familiar, a cold plunge is a specialized ice-cold bath. It’s great for inflammation and pain – and for beating back seasonal maladies.
It has an incredible number of benefits. My favorites are the connection with longevity and the activation of brown fat.
Anyway, I’m such a believer that I bought one for my basement so I could jump into it for five grueling minutes every morning when I’m in town.
Really, it’s just a tub that’s got chilled water in it. But it works wonders.
Jack Dorsey, CEO of Block (formerly Square) and founder of Twitter, is another big fan of chilling baths.
I’ll grant you that those first few seconds are downright unpleasant – a shock to the system followed by some pins-and-needles pain.
But the shock goes away quickly.
And the long-term benefits are huge. (As I told some of my TradeSmith managers in a meeting, following my aforementioned cold plunge, I woke up the next morning feeling pretty doggone great.)
Look, it’s not fun at all. But it feels great when you’re on the other side. It’s just like investing.
Subjecting yourself to a cold plunge isn’t something reserved just for your body.
It’s a move most investors need to make in the face of bear-market-itis.
You need to dump your losers.
I understand that it’s not an easy move to make. You know in advance that there’s going to be that same shock to the system… that same pain or discomfort.
But just as the pain of a cold plunge goes away pretty quickly, so does the pain of dumping your losers. And like a cold plunge, this “treatment” puts you back on healthy footing.
This is especially true in the face of a bear market like the one we’ve been navigating… or the recession we seem to be careening into.
You need to get your head around this cold-plunge/dumping-your-losers strategy to fully understand its benefits. And achieving that crucial understanding is exactly what I’m going to help you with today.
Separating the Good From the Bad
As a successful software developer and serial entrepreneur, I’m all about “best practices” in my business efforts.
And I bring that same “best practices” mindset to my personal investing efforts – and to the investing products and strategies we develop at TradeSmith.
You’ve heard me talk about those best practices – by focusing on dividends, “forever stocks,” cash flow, economic “moats,” buying businesses and not stocks…
And risk management – which includes selling your losers.
The fact is that investing is really an exercise in probabilities and risk management.
Even the best ideas can, and do, fail.
So how do we know which stocks to cut – and when to cut them?
Start by keeping it simple. Have a game plan before you make an investment.
Before I buy any stock or take any options position, I make sure to determine three things…
- The reason behind the investment
- The points along the way where I’ll reexamine the trade, justify it anew and assure myself it continues to make sense
- The maximum “pain point” (quantified by a stop loss) where I’ll sell the stock or close out the options trade – no matter what.
If the reason gets “broken,” if I can no longer justify the holding or if that “pain point” is reached, I take the “cold plunge” and cut the investment loose.
For traders, this is all pretty straightforward. You find a setup or probable pattern; select your entry, stop loss and profit target; and place the trade.
It’s a little more difficult for investors.
Take the recent collapse in technology growth stocks. Investors believed that many of these companies – ventures like Carvana Co. (NYSE: CVNA) and Twilio Inc. (NYSE: TWLO) – had long runways to spool up their businesses. Investors believed there would be big profits far in the future – which persuaded them to imbue those companies with hefty market valuations.
But that kind of valuation model makes sense only in a period of low interest rates and a predictably healthy economy.
With inflation raging, the U.S. Federal Reserve changed that calculus.
Take a look at the weekly chart below for Carvana.
If you had followed our TradeSmith Finance signals, you would have entered a position just shy of $100 in May 2020. The stock peaked just above $360 before it rolled over and hit its $184 stop loss in early January of this year, at which point you would have sold your shares.
This is a great example of a “cold plunge” that would’ve kept you healthy: Today the stock trades at around $7.
What’s especially interesting is that the stop loss was triggered around the same time that I would have said the Fed’s expected actions changed the landscape.
That’s a big reason I rely heavily on our tools. They make decision making easier by removing emotion and instilling a discipline that’s easy to see, explain and adhere to.
No One Likes to Lose
Dumping stocks for a loss isn’t fun.
In fact, it downright stinks.
Yet it’s a rite of passage for every trader and investor.
As I mentioned earlier, stocks and options are exercises in probability. That means we sometimes have to take losses.
We know that intuitively.
So why is it so tough for us to take a loss?
I was talking with a friend of mine who’s a trader.
For years, he struggled to accept his losses – because he didn’t consistently win. Without the conviction that his wins would outweigh the losses, he feared taking a loss. Ironically, that made his problems worse.
No one can successfully navigate the market over time without employing proper risk management.
A big part of that is limiting our losses.
Remember, if you take a 50% loss on a stock, the share price has to double just to get you back to even. Only then can you get back to actually making money. And the probability of that happening is pretty low.
That’s why it’s best to take that “cold plunge” – and endure the near-term pain of dumping the stock – before you get to a 50% loss.
What most of us don’t realize is that a dollar won or a dollar lost is still a dollar.
In other words, every dollar you save yourself is worth the exact same amount as every dollar you win.
Winning and losing are just different sides of the same coin. Once you realize and accept this simple truth, it becomes much easier to understand why it’s just as important to manage a losing position as a winning one.
Follow the Plan
Naturally, that leads to this question: How does someone learn to cut their losses?
As I said at the outset, successful investing starts before you buy a stock or an option.
An easy way to create this kind of discipline is to keep a journal.
With each stock or option trade you consider, write down those three things I mentioned earlier: your reason for entering the position, the points at which you’ll reevaluate it, and the point at which you’ll take that “cold plunge” and close it out.
And be sure to follow through with a review process.
Take 15 minutes or half an hour every week to scroll through your positions and check that none of the criteria has been violated.
Personally, I use the stop losses from TradeSmith Finance to make sure I stay on track. This not only automates the regular review but also removes the emotion and gives me algorithms that signal when it’s time to sell.
Look, I get that not everyone is comfortable turning their future over to a computer. Just like not everyone is comfortable with a “cold plunge.”
But both lead to robust health.
I can say that with sincere confidence about TradeSmith’s tools, thanks to the development work, market analysis and rigorous backtesting that have gone into our systems.
However you choose to go about it, make sure that you do so with clear, objective criteria that can tell you unambiguously whether to keep or drop a position.
And when you do come face-to-face with a loser, take the “cold plunge” and cut it loose.
It’ll sting in the near term, but it’ll leave you feeling healthy in the long run.
And it’s in the long run where the real wins – the real wealth – are created.