Question: How, Exactly, Do I "Keep My Losses Small?"

I'll say this about stock market strategists - the kind you see on CNBC, Fox Business and Bloomberg TV....

Having watched them up close in my days as a stock market journalist, and watching them on various streaming stock market programs now, I can tell you that they're smart people - but really no smarter than you or I.

I remember interviewing Goldman Sachs' strategist Abbie Joseph Cohen many times in the 1990s. Like all strategists (and newsletter gurus like yours truly), she was wrong as often as she was right on her market calls.

But having a well-known financial brand affixed to the end of your name gives you instant respect.

Market strategists are great communicators, too. They have a politician's instinct for deflecting questions they don't want to answer - while sounding profound and approachable at the same time.

Keeping Losses Small

For example, there's a question I often tossed at strategists and other kinds of market experts during what's called the pre-interview "warmup."

It's the point, just before the cameras get rolling, when the lighting, sound and video technicians make all their adjustments.

I often used those periods to throw questions at the strategist out of a sense of personal curiosity.

Here's one I asked many, many times over the years:

You know the old market saying that we need to "Keep your losses small, but let your winners run?"

I'd get a nod from the guest.

"How, exactly, does someone do that - keep losses small?

And I really wanted to know. I was doing my own trading and investing. But there was a lot I didn't know. Who better to ask than a true Wall Street expert sitting in front of me?

The strategist would inevitably blink, then take a moment to gather up an informed response:

"Well, Jeff, the main thing is to never bet more than you can afford to lose."

Wow. Profound.

As a response, it's clever because it says nothing, but sounds worldly-wise. A few suggested equal-weighting stock purchases (dividing a portfolio by 20 or 30, and buying equal amounts of 20 or 30 stocks).

Ultimately, I realized that none of the market strategists and other "experts" really had no idea. Most gave me the same "non-answer answers" as all the others.

I found that frustrating, but also eye-opening.

What it told me was when you're trading someone else's money, losing chunks of it doesn't matter so much. You can get fired. But it's not your money. Know what I mean?

But when you're trading and investing your own hard-earned funds, it's another matter entirely.

I needed a tool...something I could use in a real, practical, way.

Ultimately, it's how I came up with what I call "The Hidden Formula."

I didn't know it yet, but I was really seeking a way to measure risk. But how does one go about doing that?

How to Keep Your Losses Small

Ultimately, I found the answer in books and articles about poker and general card gambling, similar to this one I found more recently on the internet.

It turns out that "risk management" is a huge part of success among professional card players.

For example, a good card player must navigate through a phenomenon called "variance."

He knows he may sit down at a gaming table and be dealt 5 or 10 hands in a row with less-than-ideal card combinations. He doesn't have an edge with those combinations. He knows it. So eventually he folds (quits the game), and loses the money he bet in the round.

So the card player has to guess-timate...

1. How many times in a row could he be wrong?
2. How much is he willing to lose on each round before his odds change?

The answer is expressed in the idea of one's "risk size" or "betting size."

Think about it this way...

A pro card player comes into a casino with $10,000 cash. And let's presume that, with a string of losses, there's no ability to tap his ATM or credit card, or get a line of credit from the casino.

If he risks 5% - his "risk size" - on each hand, and loses 10 times in a row, he could wind up losing half of his original $10,000 stake ($500 x 10 hands) before he (maybe) starts winning again.

If he risks 3% on each hand, with the same 10-hand losing streak, he'll be down 30% on his original stake before his luck turns.

If he risks 1% on each hand, he'll be down 10% with a 10-hand losing streak.

The amount of risk to take depends on the person. Every gambler is different. But the important part is to figure out how to control risk so you can stay in the game long enough until the probabilities turn in your favor.

We can do the same as traders and investors.

All we need to do is figure a few things...the market price of a stock and the price where we would sell for a loss if we're wrong (i.e. the stock goes down instead of up).

For example, let's say I have a $100,000 portfolio, all in cash. I want to buy a stock. All I need to do now is follow the 5 steps:

Step #1: I find the market price of the stock I want to buy. Let's say it's a stock trading at $50.

Step #2: I find my "sell at a loss" price. Let's say it's $30 - which is 40% below the market price.

Basically, I need to find the price level where I'm going to say I was wrong, and sell the stock for a loss, rather than ride the shares to deeper and deeper losses.

Step #3: Determine my "risk factor" by subtracting my "sell at a loss" price from the market price of the stock. So if I subtract $30 from $50, my risk factor is 20.

Step #4: Determine my "risk size". If it's 1%, then I'd be risking $1,000.

Remember, I'm not buying $1,000 worth of stock though. That's how much I'm willing to lose if I'm wrong.

Step #5: I divide $1,000 by my "risk factor" number in step #3.

The answer is 20. I can buy 20 shares of stock.

Now I know exactly...if I choose to risk 1% of my portfolio on a trade, I know I can buy 20 shares of stock. And if I'm wrong, I'm out my $1,000.

I also know that - like the pro gambler in the casino - if I hit a losing streak, and I'm wrong on 10 trades in a row, I will have lost $10,000, which is 10% of my original cash portfolio of $100,000.

I can recover from a 10% loss reasonably fast. A 20% or 30% loss takes a lot longer.

I can only speak for myself. But when I started using the formula, the process felt very free-ing.

It wasn't that I stopped having losses in my trades. Losses are part of the stock market game when we invest or trade. Most of us hate the idea that we are gamblers with our stock market accounts. But that's what we're doing - taking chances.

But, by defining my risk with the steps above, I have a pretty good idea of what I'll lose if I'm wrong.

But I also know how to react if I have a string of bad trades. In a bear market, our odds are very high that we'll have a string of bad trades whether we make them over a period of weeks, months, or years.

And if I sense that perhaps things are getting better in the stock market (which doesn't appear to be the case anytime soon, right now), I know the probabilities of success may be turning in my favor.

Best of goodBUYs,

Jeff Yastine