Affordable Losses

By Michael Melissinos, founder of Melissinos Trading, edited by Niels Kaastrup-Larsen  

Trend Followers don’t shy away from losses.

Losses provide valuable feedback that helps them improve as traders. Sometimes, losses occur despite solid strategies and perfect execution. Such is life when participating in markets. Some trend followers break down, change their approach and pursue a career of trying to find consistent gains day after day, month after month, year after year. Every so often, all traders experience a painful losing period that can last a while. Trend Followers, after conducting endless hours of research, know that their strategy will experience losses from time to time. They accept this from the very beginning before they even make a trade with real money.

In general, “fundamental” investors take losses personally and purposely try to avoid them.

They have positive intentions though. They want to protect themselves from the feelings that come up during losses; that sinking feeling in their stomach; headaches; cold sweats that comes with anxiety. Fundamental Investors avoid losses; instead, preferring to be right and feel smart. As a result, they sometimes ignore the reality and hold onto losing positions - sometimes long enough to put themselves out of business. Here’s an all too common exchange between two very different types of investors - Fundamental Investors and Trend Followers. Fundamental Investor: “XYZ has to rise. The fundamentals are strong – earnings growth is positive; valuation is reasonable; it’s positioned well in a vibrant industry.” Trend Follower: “Hmm…well, despite your optimism, I notice the stock price moving downwards.” Fundamental Investor: “Yea, but this is a temporary dip. It has to go back up at some point. The fundamentals are too good for it to stay down.” Trend Follower: “Maybe, but what if it keeps going down? What if its strong fundamentals aren’t enough to make it move higher? What if the broader market fundamentals and sentiment drag it down? Your analysis won’t mean sh*t then.” Fundamental Investor: “You’re a simpleton technical trader. You care only about the price now. You do not and cannot see the stock’s future potential like me. I know this company inside and out. Based on its fundamentals, this stock will be a home-run one day. Any dip in price should be viewed as a buying opportunity.” Trend Follower: “I don’t need to know the fundamentals if I know the price. Nothing else matters besides the price. If I buy a stock that appreciates in price, I make money regardless of what the fundamental story is. Plus, earnings reports can be easily manipulated. The stock price is real; it cannot be faked; it’s the only thing that can be trusted.” Fundamental Investor: “Whatever, trend boy.” Back to avoiding losses – in all likelihood, investors avoid losses because they don’t want to accept them as part of the deal. They simply want to win all the time. Those who do the work, and who don’t live in fantasy land, know that this is impossible to achieve, so they prepare for losses by budgeting for them. As a result, these investors, humbled by the facts that research taught them, learn that budgeting for losses can help improve overall returns better than trying to avoid losses altogether. Trend Followers accept losses as part of the process – a cost of doing business, if you will, on the path of achieving long-term success. Before placing a trade, trend followers assess the market, its behavior and their financial condition (what positions they currently hold; risk exposure in each position, sector and portfolio overall; their capital base). Trend Followers take risks within their budget, so if a particular trade does not work out, they lose an amount within our budget. When you take risks within your budget, you survive; you survive through the dips with enough capital to take advantage of the big opportunities when they come along.

Make losses affordable and learn to live with them, especially you “win-at-all-costs” alpha males out there. Take small losses more frequently, so you can avoid big ones in the future.