I never get sick. Never. So when I returned from a recent trip to New York and started feeling the chills, aches, and other discomforts of a spiraling virus, I resorted to my usual panacea. A cold plunge.
For those of you who are unfamiliar, a cold plunge is a specialized ice bath. It’s great for inflammation, pain, and warding off seasonal illnesses. It has an incredible amount of benefits. My favorites are the link to longevity and activating brown fat.
Anyway, I’m such a believer that I bought one for my basement so I could hop in it for a grueling five minutes every morning when I’m in town. In fact, it’s just a bathtub that contains ice water. But it works wonders. Jack Dorsey, CEO of Block (formerly Square) and founder of Twitter, is another big fan of cooling baths. Granted, those first few seconds are downright nasty – a shock to the system followed by a stinging pain.
But the shock passes quickly. And the long-term benefits are huge. (As I told some of my CommerceSmith managers at a meeting, following my aforementioned dip in the cold, I woke up the next morning feeling pretty good). Look, this isn’t fun at all. But it feels good when you’re on the other side. It’s like investing! Submitting to a cold dive isn’t something just for your body.
This is a decision most investors have to make in the face of a bear market. You need to dump your losers. I understand that this is not an easy process to do. You know in advance that there will be the same shock to the system…the same pain or discomfort. But just like with a cold dip, the pain of throwing your losers goes away pretty quickly. And just like a cold dip, it’s a “treatment” that puts you back on a healthy footing.
This is especially true in the face of a bear market like the one we’ve navigated, or the recession we seem to be heading into. You need to be familiar with this cold dive/dump your losers strategy to fully understand its benefits. And coming to this 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 endeavors. And I bring the same “best practice” mindset to my personal investing efforts – and to the investment products and strategies we develop for you here at CommerceSmith. You’ve heard me talk about these best practices – with a focus on dividends, “permanent stocks”, cash flow, economic “moats”, buying companies not stocks. And risk management – which includes selling your losers.
The point is that investing is really an exercise in probability 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 making it simple. Have a game plan before making an investment.
For example, when I’m grilling with my family (something I love to do) and looking to cook a good steak until it’s medium-rare, I know before I even start that the optimum temperature should be around 135 degrees. Fahrenheit for my taste. Too often we complicate the trading and investing we do by failing to set clear parameters from the start. Before I buy stocks or take options positions, I make sure to determine three things:
- The reason for the investment.
- Points along the way where I will re-examine the craft, re-justify it, and make sure it continues to make sense.
- The maximum “pain point” (quantified by a stop-loss) where I will sell the stock or close the options trade – no matter what.
If the reason is “broken”, if I can no longer justify the holding, or if this “pain point” is reached, I take the “cold plunge” and cut the investment. For traders, this is all quite simple. You find a likely setup or pattern, select your entry, stop-loss and profit target, and place the trade. It’s a bit more difficult for investors.
Consider the recent crash in tech growth stocks. Investors believed that many of these companies — companies like Carvana Co. (CVNA) and Twilio Inc. (TWLO) — had long leads to expand their businesses. Investors thought there would be big profits in the distant future, which persuaded them to imbue these companies with high market valuations today.
But this type of valuation model only makes sense in a period of low interest rates and a predictably healthy economy. With soaring inflation, the US Federal Reserve changed that calculation. Take a look at the weekly chart below for Carvana.
If you followed our TradeSmith Finance signals, you would have entered a position just below $90 in May 2020. The stock peaked just above $350 before rolling and hitting its stop-loss of $175 in early January this year , the date on which you would have sold your shares. This is a prime example of a “cold dip” that would have kept you healthy: today the stock is trading around $26.
What’s particularly interesting is that the stop-loss was triggered around the same time I would have said the expected Fed actions changed the landscape. This is a big reason why I rely heavily on our tools; they facilitate decision-making by suppressing emotions and instilling discipline that is easy to see, explain, and respect. It is important to understand why losses like the one suffered by CVNA occur. Companies that see their stocks roll often don’t have the economic moats, cash flow, strong business models, or sustainability that drive stock prices to soar.
nobody likes to lose
Dumping stocks for a loss is no fun. In fact, it really stinks. Yet, it is a rite of passage for every trader and investor. As I mentioned earlier, stocks and options are exercises in probability. This means that we sometimes have to take losses. We know this intuitively. So why is it so hard for us to suffer a loss?
Well, knowing something is one thing, but overcoming our emotions to move is another. Most people are afraid of losing. I was talking with a friend of mine who is a trader. For years he struggled to come to terms with his losses – because he didn’t consistently win. Without the belief that his gains would outweigh his losses, he feared suffering a loss. Ironically, this made his problems worse.
No one can successfully navigate the market over time without using proper risk management. Much of this limits our losses. Remember that if you suffer a 50% loss on a stock, the stock price must double just to get you back on your feet. Only then can you start making money again. And the likelihood of that happening is pretty low.
That’s why it’s best to make that “cold dive” – and endure the short-term pain of a stock dump – before you hit a 50% loss. What most of us don’t realize is that a dollar gained or a dollar lost is still a dollar. Let that sink in for a moment. Every dollar you save is worth exactly the same amount as every dollar you earn. 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 managing a losing position is just as important as a winning one.
Follow the diet
Naturally, this begs the question: how does one learn to cut their losses? As I said at the beginning, a successful investment begins before you buy a stock or an option. An easy way to create this kind of discipline is to keep a journal. With every stock or option trade you consider, write down these three things I mentioned earlier: your reason for entering the position, the points at which you will revalue it, and the point at which you will make this ” cold plunge” and close it. And be sure to follow a review process.
Take 15 minutes or half an hour every week to scroll through your positions and check that none of the criteria have been violated. Personally, I use the stop-losses of TradeSmith Finance to make sure I stay on track. Not only does this automate the regular review, it takes the emotion out of it and gives me algorithms that signal when it’s time to sell. Listen, I understand that not everyone is comfortable entrusting their future to a computer. Just as not everyone is comfortable with a “cold dip”.
But both lead to robust health. I can say that with sincere confidence about CommerceSmith’s tools, thanks to the development work, market analysis and rigorous backtesting carried out in our systems. Whichever way you choose to go about it, be sure to do so with clear, objective criteria that can tell you unambiguously whether to keep or drop a position. And when you come face to face with a loser, take the “cold plunge” and let go. It will sting in the short term, but you will feel healthy in the long run. And it is in the long term that the real gains – the real wealth – are created.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.