Marking Positions to Market

One

exercise I find particularly useful in a market like this is marking

all positions to market. That means viewing every position as if I just

bought it today at the current price. Unrealized gains or losses become

irrelevant. What matters is the play I would have if I bought the stock

right here based on where it is trading now and what the chart looks

like today.

This approach forces clarity on positions that have

slipped and where inaction has set in. One of the most damaging patterns

in trading is freezing when a stock acts poorly, ignoring the

deterioration, and hoping it comes back. More often than not it

continues lower and in many cases will not see a meaningful recovery for

a very long time. The mark-to-market reframe breaks that inertia. Set

clear stop levels based on the current price. Build a strategy around

the revised cost basis. And keep in mind that selling is never final.

You can always rebuy if conditions change. Be ruthless about having a

plan and sticking to it even if it feels like you are admitting a

mistake by not selling earlier.

The power of compounding is what creates great market wealth. Last week I discussed how important it is

to make sure that your accounts keep hitting new highs. Making up

losses can set back your progress for years because it robs you of the

time and benefit of compounding.

The theory is easy to understand.

If we want to enjoy the power of compounding, then we have to keep

accounts as close to highs as possible so we do not waste time making up

losses. The hard part is actually doing it. How do we avoid sizable

pullbacks and the time and effort it takes to get back to highs?

Before

discussing strategies and tactics, it is essential to understand

drawdowns. A drawdown is the decline from your account's peak. It is the

amount of capital you have to recover to return to highs.

Drawdowns

are inevitable. The only way to avoid them entirely is to take no risk

at all. You are unlikely to experience any drawdown in a bank account,

but you are not likely to see any substantial returns either.

The

first question to consider is what constitutes an acceptable drawdown.

That depends on your trading and investing style. The more aggressive

your approach, the greater the potential drawdown. A maximum drawdown of

10% may work for conservative investors in lower-risk positions, but a

30% drawdown may be acceptable for aggressive traders in high-volatility

stocks with high betas. Much will depend on stylistic factors like

diversification, concentration, and time frame.

If you are

shooting for returns that exceed the indexes, you have to be willing to

live with higher volatility and bigger drawdowns. You will get burned

and suffer some significant losses at times, but if your approach is

sound, you will be able to make up those losses fairly quickly with new

trades that work.

The more difficult problem is when the drawdown

is disproportionate to the volatility inherent in your style. If you are

using a conservative approach and aiming for 10% annual returns, a 30%

drawdown puts you in a very difficult situation.

Once you have a

feel for the average drawdown that your trading style produces, you can

start to design a system that uses reasonable stop levels to prevent

losses from growing too large.

Setting Stops

Setting

stops can be extremely difficult and frustrating because they will

never be perfect. Your stop level will often be the exact low for the

stock because that is how the Market Beast operates. In retrospect, you

will feel like a fool for selling your great stock when you did. So the

next time it starts to sink, you will be inclined to ignore the stop

because the stock is sure to bounce right back. That lack of discipline

will occur just as the stock continues to drop like a falling safe.

The first step in keeping accounts close to highs is figuring out effective stop levels. Some

traders use a fixed percentage, such as 8 or 10 percent. For

high-growth momentum stocks, it is often too tight, so I tend to give my

high-volatility names more room. I will discuss this in much greater

detail in future columns, but put in place some reasonable stops and

treat them as firm.

The second step is discipline. Honor

those damn stops. Do not ignore them. Do not come up with

justifications for suddenly changing them. It is what separates

successful traders from unsuccessful ones.

The Stop-and-Rebuy

One

thing that can make stop discipline considerably easier is the rebuy.

Just because you are stopped out does not mean you cannot buy the stock

again. The stop-and-rebuy tactic is extremely powerful. Once you are out

of a position, it relieves you of a substantial amount of emotional

baggage, and you can be much more objective about the wisdom of getting

back in. Does the stock still hold the same attraction after you have

sold it?

Investors often fail to recognize how much relief comes

from exiting a stock that has been causing anxiety. It is very easy to

underestimate how much emotion is interfering with a balanced view. If

you do not own it, the analysis is far more objective.

The biggest

problem with the stop-and-rebuy tactic is simply doing it. It takes

time, effort, and planning. You not only have to set reasonable stops,

but also continue monitoring the stock and evaluating it for reentry.

That is considerably more work than telling yourself this is a great

stock and you are going to hold on no matter how deep the drawdown gets.

There

are many nuances to the stop-and-rebuy approach, but the most important

thing is to embrace the concept if you want to limit portfolio

drawdowns. The only way to keep accounts close to highs is to cut losing

stocks before they do sizable damage.

Successful investing always

comes back to the same fundamental truth. Higher returns require

greater risk. There are tactics that can reduce that risk, but they come

with the cost of strict discipline that demands time and effort.

What I Am Watching

In this type of

market, the single issue that drives my buying decisions more than

anything else is relative strength. The stocks holding up best right now

are the ones most likely to attract aggressive buying interest when

conditions improve.