Two thoughts that go through our head consciously with every single trade; “What if we are wrong.” and “How will we know?” These, to us, are probably the most important questions any trader or investor can ask themselves. Why is this?
For starters, these questions are the beginning and the essence of risk management. It has been proven that most people think they have a much higher investment efficacy than they actually do, meaning they think they are better investors than they actually are. They think they know something others don’t, which is why the trade will work out in their favor.
Great traders and investors on the other hand know that they probably don’t know everything and odds are that the trade probably will not work out. The difference here is most traders and investors focus on the upside while great traders dial in on the downside.
Secondly, asking these question gets the brain working on a completely different path than if they weren’t brought up. The brain starts taking the otherside of the trade or investment which consequently starts to naturally detach emotions over the decision and looks at it more objectively. It is no wonder that debaters are often more successful taking the opposite side of a debate then they believe. It naturally makes a person more objective.
Does this get rid of emotion in the decision, I wish it were that easy, but no it does not. Emotion drives anything into action. Without emotion there would be no action, so we like emotion, just not superfluous emotion that is not helpful to the situation. This is an entirely different topic that we would like to discuss in another post but for now we will leave it at that.
Back to our questions, “What if we are wrong?”, and “How will we know?” The one thing that astounds us about these questions is that most people when trading or investing don’t ask them and for sure don’t answer them.
Actually, with most retail investors the first question, “What if I am wrong?”, would be phrased a different way, “What if my beliefs about the market are wrong? or “What if my broker is wrong?” or “What if my money manager handling my 401K is wrong?”
The first question in its most basic form just takes the opposite side of your current action or belief system but the second question, “How will I know?”, gets the mind thinking strategically. For in order for you to know what will happen if you are wrong, then you will have had to think through to know when your decision turns from “right” to “wrong”. And if your decision is wrong, what action must be taken?
This is the essence of actual risk management.
For most good traders this is second nature to always ask these hard questions in order to quantify risk as best as possible, but for most others we have found these questions to be completely foreign. Even in the finance industry which holds itself out to “manage risk” we haven’t been able to get a handle on how they are answering these questions.
For most of the finance industry, risk management is done through “stock and bond diversification”. The thought is that you can diversify most of your risk away by being in many different stocks and bonds. Some go up while others may go down. Does this work?
Well most people found out that the flaw in diversifying in only two asset classes is most to all correlations in an asset class go to 1 during times of panic. This means that when you need diversification the most is when it fails. That is why peoples 401-K plans got nailed in 2001 and 2008 because the two asset classes they were in, stocks and bonds, were pummeled.
How about another instance, buy and hold investing. What happens if the investments you bought are wrong and how will you know? Most people have there money wrapped up in 401-K’s that are subject to “long only” buy and hold investing. They make money only when the stock or bond market go up. They are 90-100% invested all the time but are “diversified in stocks and bonds” in order to “manage” risk.
What if this is wrong? How and when will you know it is wrong?
Most people say they don’t try and “time” the market but at some point they need the funds they are investing for retirement, child’s school, etc. which to us seems like market timing. Will you know if the strategy is wrong then, when you need to take the money out?
With peoples retirements over the past 12 years getting little to no growth but suffering huge volatility, is the strategy working? We are not the judge and jury for that and will let investors answer that question for themselves but we would like people to start really asking these difficult questions about their investments and know there are other options.to subsist as long as we are trading.
We appreciate any feedback or comments. Have a great week.