Making Decisions In The Face of Uncertainty

A close friend of mine likes to manage his investments personally. He is a beginner in investing and sets his investment horizon on the medium to long term. One fine day he gave me a ring to ask for my advice.

He says he is a trend follower and uses simple rules to keep his portfolio out of trouble. His rules are straight forward, when the market crosses above the 50 exponential moving average on the weekly chart, he buys. If market stays above the moving average, he stays invested. If the market crosses below the moving average, he exits. Straight forward rules, simple to follow and effective when the market is trending.

“So what’s the problem?” I asked him.

“I am currently long the market and it’s about to cross below the 50 moving average. According to my rules I should sell to close off my position” He replied.

“And?” I probed.

“What if the market turns back up later? My decision to exit would be wrong because I would have sold at the market low, suffering a loss for nothing. And it’s not just that. When I reenter the market later, I will be buying at a higher price! Wouldn’t that put me in a worst off position than if I just did nothing?”

“So you are not sure you want to close off your position” I said

“But then again, if I don’t exit now, what if market drops further? My losses will surely accumulate! So what should I do? How can I be sure I am making the right decision?”

I realized that my friend needed a different perspective.

The challenge my friend faced is one of uncertainty. Uncertainty says “How do I make a decision today when I don’t know what will happen tomorrow?” To that I say we must first clarify our objectives and then prioritize them. My friend needs to see that he is trying to avoid losing money and avoid losing opportunity both at the same time. I explained to him that I don’t see how he can achieve both at the same time especially when we have no control over the market.

Our first priority in this business should be to preserve capital. When and only when this is taken care of do we look to maximize profit. The truth is, if we do not manage our risks well, we will never be able to stay long enough in the business to reap the rewards.

All too often, many traders and investors mix up the priorities in this business. Many think that maximizing profit potential is all important and do not see the consequences of mismanaging their risk. If my friend chooses to hold on to his position, flout his own rules and the market happens to turn up, this will be the worst possible outcome he can experience. Why? Because this will teach him to mismanage risk in the name of profits, the self destructive path that leads to account decimation.

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Seasoned traders often say that when we take care of our risks, profits will take care of themselves. I had to learn this the hard way. I hope my friend doesn’t have to.

Good Trading,
Ethan