Lessons We Learned in Kindergarten Could Be Eating into Our Gains

Editor's Note: Many individual investors struggle to cut losses because of an aversion to being wrong. It's a hard habit to break, but successful investing depends on it. Here's how to unlearn what you have learned and become a successful "aggressive-conservative" investor...

Most individual investors, whatever their background, don't want to cut losses because they're programmed since childhood with an aversion to... being wrong.

We all want to be right.

As a result, they sit, paralyzed, in losing trades far longer than they should, letting small (manageable) losses turn into huge (catastrophic) losses.

It's unsurprising, if you think about it. It's all in the programming.

Most professional traders, on the other hand, don't have this problem. In fact, they don't particularly care if they are right on every trade. This sounds crazy, but it's not uncommon for a professional trader to be wrong 75%, 85%, or more of the time.

In fact, I remember legendary trader Dennis Gartman explaining once that the more trades he was "wrong" on, the more money he made at the end of the year.

Let me show you how this counterintuitive, profitable mindset works. You're going to love the gains you start pulling down once you see this...

Profit Comfortably... and Be Wrong 80% of the Time

Like I said, this sounds strange, but it's actually really simple:

Keep your losses small. Very small. And let your winners run.

Basically, you're being very conservative with your downside risk while being aggressive with your gains.

A little simple math will go a long way toward illustrating this point.

If you have a $100,000 trading account and you limit your losses to just $1,000 of your overall capital, you can be wrong eight times in a row and you'll only have lost $8,000, a mere 8% of your "bankroll."

Follow those eight losing trades with two $15,000 (or 15%) winners and, bang, you're up 22%, sitting on $122,000.

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Talk about taking it easy on yourself. In this example you can be wrong 80% of the time and you're still up 22% after 10 trades.

Professional traders refer to this as "reward/risk trading," because the potential reward far surpasses the risk.

In my Small-Cap Rocket Alert trading service, we take this approach all the time, and we just took profits from our sixth triple-digit gain of 2016. At the same time, we're down on just two of 16 open stock positions as I write.

Just to be clear, I'm not suggesting you use 1% trailing stops on your positions - although you could do that if that's what fits your risk tolerance and trading style.

Instead, what I'm suggesting in the example above is that you "limit your losses" to $1,000 per trade. Obviously, that number would change depending on the size of your trading account.

For example, check out the following scenarios based on that hypothetical $100,000 chunk of capital I mentioned.

If you establish a position worth $5,000, you could absorb a 20% loss on the position and still "limit your loss" to $1,000. In this example, your $5,000 "position size" represents 5% of your overall capital (of $100,000), but the amount you're willing to risk is only $1,000 - or 1% of your capital.

Let's say you establish a position worth $10,000. You could absorb a 10% loss on the position and still "limit your loss" to $1,000.

Or you might take a position worth $20,000. Then you could absorb a 5% loss on the position and still "limit your loss" to $1,000.

You can move those numbers around till the cows come home to get different variations, but there's one very important risk-management consideration to remember...

The larger your initial position size, the larger amount of initial risk you're taking on in the event something happens in the pre-market, after-hours, or even in midday trading.

How to Use This Technique in the Real World

Like the theory, the practice is actually pretty simple...

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Identify a trading opportunity you want to target.

It doesn't matter what criteria you use: moving averages, moving average convergence/divergence (MACD), support and resistance, or chicken bones or tea leaves. The important factor is that the system you're using to identify trades fits with your personality and trading style.

Once you're in the trade, do yourself two big favors...

  • Immediately enter your downside protective stop and your profit target orders. This will take a whole heckuvalot of the emotion and guesswork out of the trade. If the trade starts to work in your favor, you can always adjust the protective stop - upward - to improve your profit potential.
  • Divorce yourself from needing to "be right" on the trade. You may have done all the homework in the world only to find out the market had a different idea. And that's totally fine. It doesn't mean you made a mistake. It just means the market had other ideas at that point in time. Just make sure you keep your loss small so you can redeploy your capital to the next opportunity to hit a home run.

There are a few more common sense points to consider to help you become a more successful conservative-aggressive investor.

Make sure you know your trade and that you've done your homework to understand typical trading patterns in the stock you're targeting. Don't just establish a position willy-nilly because some blowhard on television said it's the next best thing since sliced bread.

Homework includes making sure you're aware of when upcoming news announcements, such as earnings, are scheduled. The last thing you want is for your company to deliver bad earnings and get hammered in after-hours or pre-market trading. If that happens, you could wake up to find your stock traded well below your stop before you get your fill.

Here's another one: Don't establish a large initial position size in a stock that you are aware has a history of gapping up or down 10%, 15%, or more in after-hours or pre-market trading. I can tell you from experience that waking up one morning to find that your stock has gapped down 20%, 30%, or more in after-hours or pre-market trading is a crummy way to start the day.

Big overnight moves like these are not uncommon for small-cap stocks - even more so in small-cap biotech stocks.

In fact, in the small-cap sector, one- and two-day gains of 89% aren't unheard of.

You can even use this kind of strategy to target "Rocket Rider" trading opportunities found in the Money Map Report's 50-40-10 portfolio structure.

The real key is to shift your focus to making money over the long term rather than worrying about being right on every single trade.

You'll know it's working when you see your account balance increase over time.

Speaking of Earnings...

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About the Author

Sid is the investment community's best-kept secret. Since 2009, he's served at Money Map Press as Director of Research, analyzing thousands of securities and profit opportunities for subscribers. He's an expert in identifying "alpha" potential in a wide variety of industries, but especially the small-cap sector, where he's discovered a pattern of profits that's almost foolproof.

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