My 1st Million At 33 - yes, you can do it too

Have you ever wondered why if stocks do have a better long term performance track record than bonds, why do we even bother putting money into bonds? Have you also ever wondered that if small cap stocks have been proven to have a better long term performance, why are we even investing in large caps?

In a simple word, it’s RISK. Actually, Jeremy Siegel may be right. Investing in stocks for the long term may not be more risky because in the long term stocks do out-perform stocks. But there are obviously two problems with “long term”. First, the long term may be longer than your expected retirement horizon. Secondly only if you can ride out the bear markets successfully, you can come out winning.

What is the problem with RISK? RISK is the potential or actual amount of money or capital that you may lose from investing activities. I thought long and hard about Kelly’s criterion for investing, and why it can seldom succeed in the investing world even though it’s mathematically optimal. The answer is indeed risk. Risk must be controllable to a certain extent, or else you get out of your position before fruition.

That leads me to the three elements in investing. The three elements are yourself, the market which represents the collective opinions of everyone’s, and your reactions to the market. The biggest reason that risks do matter even though we know stocks outperform bonds in the long term is that our reactions to the market is an important part of the equation in the long term performance of our own portfolio, even though we know stocks outperform bonds in the long term. The reactions to the market prices cannot be captured from the historical studies of stocks and bonds. Without mastering our own investing emotions, we cannot become a successful investor or trader.

The market will always does it what it does, and it’s short-term efficient. It certainly doesn’t mean that the market has the correct long term opinion. Rather, it simply means that the market has not reached the prices that will be in the future. A successful investor will then try to forecast the future prices, taking advantage of the current market price, and try to control his or her risk, reactions and emotions to the market when the market does not go your way.

I don’t know anyone who can keep a straight face when his or her portfolio goes down by 50%, or even 80%. Theoretically, prices may revert back to historical norm. Practically however, very few people can ride out the necessary roller-coasters due to the emotion involved.

There have been many times that I was emotionally forced out of my positions because I took more risks than I could accept emotionally. The easiest way to control your risk tolerance (and therefore your own emotional reaction) is through a proper sizing of your positions. The more risky it is, the smaller size you should trade. That is the only way to maintain a sane trading mentality.

The second way is obviously using stop-loss order. When you think you may be wrong on a trade, just walk away. The market is about the pricing. If you are wrong, admit it.