Inexperienced investors are often surprised to learn that uncertainty breeds opportunity. In the financial markets, uncertainty can bring some of the biggest profit opportunities you’ll find. Market turmoil inevitably leads to the undervaluing of certain assets. Savvy investors can buy assets at a considerable discount to reap profits in the distant future.
This approach may seem to run counter to the default mode of profit speculation, and there are plenty of ways such a strategy can go wrong if it’s not executed with discipline and forethought.
However, investors who faithfully adopt those qualities in their investment philosophy stand a chance to make them pay off with long-term profits.
It’s all a matter of balance. As with any investment strategy, the key is managing risk and staying patient. This requires using rational analysis and resisting the temptation to act on hunches.
To maintain that equilibrium, we live by three specific rules — our three keys to success when market volatility hits.
1. Control What You Can, Manage What You Cannot
Financial markets can – and often do – fall much more frequently than we’d care to admit, often for reasons well beyond control (though investors would often like to believe otherwise).
Big declines are part of the investing landscape. We need to be prepared for them — not just some of the time, but all of the time.
When investors read this rule, their initial thought is usually that it’s meant as a warning to avoid big losses. In reality, this rule was put in place to ensure big gains.
Time and again, history demonstrates two key facts:
- The biggest stock-market returns go to investors who put capital into play when the markets are at their worst — think of the profits reaped by investors who took the plunge in 1932, 1942, 1982 and 2003.
- The worst returns go to those who invest when markets are highest — think 1928, 1969, 1999, and 2007.
As sound and clear as this bit of market wisdom actually is, it runs completely counter to what investors’ emotions tell them to do (or not to do) in their quest for long-term profits.
That brings us to volatile-market success key No. 2.
2. It’s Harder to Get Out of a Trade Than It Is to Get Into One
Few things are as intimidating as selling an investment, particularly when it’s one we “love” to own. The “why” of this reality really doesn’t matter (although psychologists who study this sort of thing suggest we hate being “wrong” more than we hate losing).
Of course, that’s why “the crowd” is wrong much more often than it’s right.
This partially explains why so many people would rather go off the cliff with the herd than step aside when it’s appropriate to do so. It’s easier to be wrong with the crowd than to risk going against what “everyone” believes to be true.
When push comes to shove, there are all kinds of rational decisions we should be making. But we don’t because of how we’re hardwired inside.
We’ve all made the same mistake and held on to an investment when we shouldn’t. All too often, we ride what should have been a small loss into a very big one simply because we couldn’t bring ourselves to sell — even though we intuitively knew that was the right move.
3. Wishful Thinking Is Not an Effective Investment Analysis Tool
One of the most common pieces of advice financial advisors give out is to eliminate emotions from your decision-making process.
While making reasonable projections is a legitimate approach to earning long-term profits, hopeful improvisation isn’t. The best way to counter wishful thinking is by instituting a systematic discipline in your investment strategy — namely, trailing stops.
Trailing stops (also known as contingent orders) help limit potential losses by triggering a stock sale when a commodity’s price hits a certain percentage or dollar amount below what it’s currently worth. Beyond that, a trailing stop can lock in profits before you take a loss if it’s set at a point above your cost basis.
Some experts, such as Investor’s Business Daily’s William J. O’Neill, advocate rather tight stop-losses (or trailing stops) of 7% to 8%. Others suggest 25%, depending on market conditions.
But in any case, we tell investors to ban wishful thinking from their analysis for a simple reason — it clouds their judgment.
Bonus Rule: There’s No Such Thing as a ‘Can’t Lose’ Investment
In March 1994, Money Magazine published a list of the “Eight Investments That Never Lose Money.” Back then, as now, the stock market had dropped, interest rates were rising and the dollar had cratered.
By the end of that year, six of the eight “can’t lose” investments were in the red.
So, what are some concrete steps you can take to incorporate these three snippets of wisdom into your investments?
- To control risk, invest in a good, balanced fund. Make it the cornerstone of your entire investment portfolio.
- Mandate the use of a 25% trailing stop (or whatever percentage fits your risk tolerance ability). But make sure you use the stops. That way, you’ll keep small losses from becoming large and probably capture more than a few big gains in the process.
- Concentrate on what the markets are actually doing rather than what you think they ought to be doing.
As Warren Buffett so eloquently said, “It’s better to be approximately right than precisely wrong.” And this is especially true in today’s markets.
On the date of publication, Sarah Edwards did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
On the date of publication, the responsible editor did not have (either directly or indirectly) any positions in the securities mentioned in this article.
