Investment Discipline For The New Year

Here is a copy of an article I wrote last week for TheStreet.com:

While the month of January is usually the time people are making resolutions for the New Year, I recently spent some time reviewing all of my trades from 2008 and taking a look at how well I adhered to my own investment philosophy and trading discipline.

The market is still extremely difficult to navigate and volatility is well above “normal” levels. As such, investors cannot afford to be lazy or make mistakes by neglecting their discipline. So let’s take a look at some of my top trading commandments, with some comments about how well I followed them:

1. Discipline trumps conviction. Don't let your bad trades turn into investments.

I did a pretty good job utilizing stop-losses on my trades, but there is certainly room for improvement. One mistake I made was taking partial profits on winning positions, but then letting the remaining shares move to a loss. That won’t happen for me in 2009.

2. Perception is reality in the market. Adapt your style to the market; and learn to accept the market as it is, not how you wish it were.

In a bear market, you can’t use bull market strategies. My mistake was thinking that the ‘Bear Stearns bottom’ might be the lows for the year. The key is to respect the dominant trend, which was down for most of the year.

3. Play great defense, not great offense. Opportunities are made up easier than losses.

My short-term hedges, using inverse ETFs, were very successful last year. They were profitable 85% of the time, but the positions weren’t big enough to offset losses on my long positions. I would have been better off letting some of these positions run, instead of being quick to take profits.

4. Don’t confine your thinking in terms of boundaries. Expect the extreme, and don’t miss major profit opportunities.

I think Paul Tudor Jones came up with this one, and it would have made you a fortune last year. For many, including myself, it was hard to imagine the biggest investment banks going to zero, but that is what happened. Going forward, I need to be more open-minded to the notion that in the financial markets, anything can happen.

5. Risk control is important. Always quantify your risk going into a trade.

This relates to #1 also. I think where my risk control was too loose was in my fixed income positions. In a bear market, don’t wait for things to “come back”. When an asset looks distressed, take the loss and preserve capital.

6. Don’t get caught in a situation in which you could lose a great deal of money for reasons you don’t understand.

I did a good job on this one, but I know a lot of investors who use ETFs blindly, without knowing what the individual weightings in them are, how well the correlate to their index, as well as the quirks of inverse ETFs that Eric Oberg has writing about. The takeaway: Know what you own.

Overall, last year was definitely one I would like to forget. Instead, I will use it as a reminder to pay close attention to my disciplines and risk management. If the market stays in a trading range, we could see several mini bull and bear cycles over the next several years. Using 2008 as a template would be constructive to help investors navigate the waters under such a scenario.

I hope readers find some of these useful, and if there are any good ones that you think I forgot and should be included, shoot me a note. Happy trading--