The Importance of Having a Plan
Successful stock traders always have a plan, and their plan tends to be a good one, as evidenced by their success. The more often you trade, the more important a plan becomes, as you’re placing more bets and therefore have to know more about what you are doing.
Infrequent bets may be able to get by without as sound of a plan, due to the randomness involved, and provided that stocks accumulate in value over time as they have in the past, then you may be able to get away with a lot less diligence.
It is always important though to have some sort of plan with stock selection, even though people might think that it doesn’t make much difference, and speak of things such as how few people beat the market so what difference does it make.
Indexes though tend to be driven by the movement of a few issues, so people who think they can be fairly random about which components they can buy and expect the same returns are usually disappointed, unless they get real lucky over a certain period.
This should not be about seeking luck though, as this is not a lottery, it is a situation where you are choosing certain assets over others with the expectation that the ones you choose will outperform the ones not chosen.
So we should be seeking to construct a plan that takes into account not only the opportunities, but your resources and what you are seeking to accomplish with the trades. We also need to account for one’s risk appetite as it is at the very least counterproductive for one to enter into stock trades that one does not have the wherewithal to execute the proper plan properly.
There are two ways to address trades which would be unsuitable, which are to look to make yourself more suitable for a certain trade or to seek more suitable trades relative to your current risk appetite.
There are actually two main components to a trade, the profitability and the risk. Having a trade be profitable, as far as the probability of it being so, is essential, but we must also account for risk. The two tend to go together, as riskier trades tend to be more profitable than less risky options, but there are still things you can do in order to mitigate the risk of a certain trade to make the trade more appealing.
The Ability to Execute the Plan
There are a lot of things to consider when putting together a plan, but the most important one is probably staying within your level of ability to both choose and execute the plan.
This is where individual investors tend to go wrong a lot, to underestimate the challenges here, or the risks, and to overestimate their ability to make the proper decision while in the trade. Finding the right trades in a lot of cases are the easy part, sticking to the plan and doing the right thing may end up being even more challenging, and this is where people mess up the most actually.
Often times, one will have a certain personal goal for a trade and then they tend to forget that the stock does not care what their goal is and will behave the way the market dictates. Stock prices are the sum total of the supply and demand for a stock and the supply and demand is what it is, and does indeed change over time, and can change a lot.
There is a progression here, which starts by looking at the different options available at a given time, which may also include not trading at all right now. If you are a long player only, and the market is falling, it’s probably a bad idea to go long anything, and it is better to wait until the downturn subsides, or that you can be reasonably certain it has.
On the other hand, large downward swings can present fabulous opportunities for those who are willing to go short, to bet that things go down, and this doesn’t necessarily mean that you have to take short positions with stocks to take advantage of this, as there are other types of securities that you can do this with as well.
Whether one is going to play one side of the market or both is one of the things that must be decided when formulating one’s plan, and one might not be comfortable with shorting right now so the plan might only be to learn this side of trading more and start dabbling in it at a later time when one is more comfortable with this.
Planning Your Exit Strategies in Advance
We need to start out by assessing, as best we can, the viability of a certain trade, and having a plan, a method, allows us to better assess how the trade should proceed and what will happen to both violate the plan and complete the plan.
A good example of this is looking to pick a bottom, perhaps there is a support area that it looks like it is bouncing off of, perhaps there’s some positive news, perhaps the market as a whole is rebounding, whatever.
So you enter the trade with the expectation that it will start to rise, and have a goal in mind, a certain movement upward. You’ve assessed the probability of being able to achieve your goal with the trade, make a certain amount of profit, with an expectation of a certain movement in your favor.
The probabilities do change though, and even before pulling the trigger on the trade, you need to ask yourself what would negate your plan, what would turn the odds from what you believe are in your favor to against you?
Aside from trading costs, commissions and spreads, people always need to be assessing trades based upon their viability at any given moment. So if you are long, you need to ask yourself, would you enter the trade long now? If it’s a definite no, then you need to seriously consider why you are still in the trade.
You do have a certain amount invested in the trade, the commissions and spread, but that’s it, you are not committed beyond this, even though people often think they are. These are sunk costs anyway, so even this stuff doesn’t matter. Your net position doesn’t matter either, whether you are up or down a certain amount. The trade needs to be assessed upon its own merits, always.
Amateurs tend to stick with trades well past the point of them being good trades, usually out of a desire not to be wrong with it, or feeling some sort of commitment to it. Successful traders realize how detrimental this attitude is, and realize that to be successful you have to lose a lot of trades as well as win a lot, and in the end, you just look to make more money on the winners than lose on the losers.
Without a plan though, who knows how well you’ll be able to assess these changing conditions, and it’s better to construct a plan before you enter the trade than decide all of this off the cuff in the heat of battle.
In our example, we will seek to envision a point where it no longer appears to be rebounding, for instance if it heads the other way in a significant enough fashion that we are confident enough that it’s going wrong, and then get out at that point. If we get out and it starts turning around, and it was clear that this was an exit, we can’t worry about the outcomes, so long as the processes are as sound as we can make them and they are based upon probabilities, not any given instance of them.
So maybe we learn from this trade, and that’s really how good traders learn, by doing, and there is no substitute for this.
Super trader Ray Dalio puts this perfectly when he says that learning to trade is a lot like learning to ski, you fall down, you get up, you keep doing this, you get better.
To sum up, the real goal is to make money, but to achieve that, you need a plan. The plan must be based upon what best achieves your goals. The better plan you have, and the better you adapt as you learn, the more successful you will be at this.