Money Management and its Importance in Stock InvestingIn 2001, we watched the stock market plummet like a rock because the Internet bubble burst. Millions of traders and investors lost money, but quite a few didn't. Investors who didn't lose it all were either lucky, or good at their game. Successful money management techniques and their intense desire to learn how to play the stock market is what saved them.
If you want to make money investing in stocks, you need to be good at money management, not lucky. A lucky streak is always well received, but the moment you require luck to succeed you'll not make the grade. They key to consistently making money by trading and investing in the stock market is dependent on your knowledge of how to lose money correctly via strict money management techniques.
Although this seems opposite to our usual way of thinking, it actually makes a lot of sense. If you expect to trade and not be willing to accept losses from time to time, it should be understood that this is not a realistic approach. The truth is many of the most successful traders lose money more often than the unsuccessful ones. However, they are still able to achieve success in the long run. There are two reasons for this:
1. Successful traders never lose a large outlay of cash on a solitary transaction.
Trades have five possible outcomes:
- Lose a large amount of money
- Lose a small amount of money
- Lose no money and make no money
- Make a small amount of money
- Make a large amount of money
Here's the secret: Find ways to diminish or eliminate the first possibility!
2. Successful traders refrain from investing too much money into a "favorite" position.
If you invest too much money into your "pet stock of the moment", you are setting yourself up for disaster. Successful traders, not unlike successful casino gamblers, establish a maximum value that can be risked in a single trade (or bet). And when even a small loss from that investment results in a large dent in your account, you are not trading optimally.
If your accounts total $1000, and you never want to risk over 5% of that on a single trade, does that imply that you can only purchase a $50 position? Absolutely not, you couldn't make money that way. In the scenario where the most you're willing to lose on any one trade is $50, you could set up a $500 trade in a way where you are guaranteed not to lose over $50. This can be done with a pre-set "stop-loss" where you instruct your broker (or program it into your stock market online investing system), to get you out of that position if that limitation is ever reached. This technique gives you the ability to know your maximum risk before making the trade.
Although not absolute, stop losses work as intended most of the time. Occasionally, various market conditions cause your broker to miss your stop-loss price. Smart traders establish stop losses while keeping this possibility in mind as part of their overall stock trading plan.
Money management is the single most overlooked aspect of trading. It's far more important to manage your account's value correctly than it is to locate the exact bottom or top of the market. Money management can make the difference between success and failure. If you're considering stock trading and investing, or if your stock market investing strategy isn't as successful as you'd like it to be, you owe it yourself to become an expert at this technique.