Risk and money management methods are very easily accessible nowadays. A plethora of different order types for trading and investing purposes, dozens of assets designed just to protect your capital, and excel sheets, programs, and applications that help you in optimising your portfolio are readily available for free or for a very low price.
Today, I won’t talk about those though, as I believe risk management starts (and ends) inside your head, and if your mental risk management framework is not ready, no fancy tool will be good enough to protect your capital.
Your Head is the Battlefield
Trading and investing are both mental games. In theory, these disciplines are simple enough to learn the basic rules in a matter of days and sum up the most important commandments on a piece of paper. That said, with the psychological demons like mental accounting, confirmation bias, and cognitive dissonance always lurking in the footsteps of investors, it is a mighty challenge to keep your strategies simple and your expectations rational.
Save, Invest, Wait, Evaluate… and Repeat
The magic of compounded returns works for everyone, no matter of your educational background, your financial education, or any other factor. As Jonas emphasised in his great article recently, your saving and consumption patterns have probably the strongest effect on your wealth in the long run. I would add that controlling your emotions and being conscious about your investments is almost as crucial, as a few small mistakes that create a snowball effect could lead to severe losses in any part of your investment career.
The Mental Risks
The most important challenges that you will face in the financial markets are not wars, recessions, or currency crises, even though those are events that might drastically change the playing field. With a balanced approach, your long-term returns won’t be that much affected by them, especially if you pay attention to the crucial aspects of the mind game.
The biggest issues that we have come across are:
- Mental accounting and confirmation bias
- The fear of missing out
- Expecting only “normal” outcomes
- Blindly following “gurus”
We already covered some of those issues in our previous posts (illustrated by some painfully personal memories), but let’s see how to deal with the others as well.
Manage Your Expectations
Overconfidence usually rears its ugly head at the time of your first meaningful success. You will extrapolate your returns indefinitely and arrive at the conclusion that you will buy your first Yacht in about a year. Don’t get me wrong, that might the case, but it’s more likely that there will be some, minor or serious, bumps ahead, so setting realistic goals is essential for success. And by realistic goals, I don’t mean that you can’t shoot high—if you start saving 33% of your income now, for example, you will be surprised how quickly your investments might add up.
Prepare for Losses
There is no such thing as a perfect strategy, period. Even the smartest and most successful investors lose money sometimes. The difference between the average Joe and the Warren Buffets of the world is that the latter not only do everything to avoid losses, but also have a plan B if things go south.
This is especially true if you decide to take on short-term trades. Remember a trading strategy that has a 70% success rate is an exceptional one, meaning that you will lose three out of ten times. If you are not prepared mentally for that, trading is not for you.
Expect the Unexpected
In the real world countries and companies do go bankrupt, successful firms do grow a hundred times in a few years, and currencies do lose 90% of their value in a matter of months. The real risk is the fact that investors think that everything will be nice and smooth and the average returns will simply show up on their bank accounts every year.
The reality is that the bank itself might not open one day. “Out-Of-The-Box” thinking is a serious buzzword, but to be honest, that should be the normal, and your portfolio should be way more bullet proof than “common knowledge” (or financial models for that matter) dictates. Just ask those who were convinced that the Swiss National Bank won’t let the Franc go…
Make your Own Decisions
Following investment and trading advice, or putting faith into investment professionals are not bad things by default, in fact having a portfolio of advisors you trust could be a game-changing asset. That said, doing that unconditionally or without “translating” the advice to your language and applying them to you own situation is truly hazardous. Everyone makes mistakes, every strategy will fail from time to time, and not taking that into account is a foolish thing to do.
As you can see we didn’t invent anything new in this post, in fact, most of it is common sense. Some might argue that it’s nothing substantial or even simply bullsh*t. But it’s not a coincidence that the title of the post has the words “start”, “practicing” and “now” in it. A lot of investors know about these simple things, but choose to ignore them. We encourage you to the exact opposite and take small steps every day towards becoming a more conscious investor.