Knowing Where To Get Out Before Getting In
The one thing that is certain in the market is that nothing is certain. This is similar to the old Socratic Paradox, "I know one thing: that I know nothing". In other words, while everyone, and I mean everyone, has an opinion of what will happen next, we really have no idea of what's going to happen tomorrow. So blindly putting on a position without first having risk management procedures in place doesn't make a lot of sense to me. Remember, we're not in the business of being right, we're in the business of making money. There's a difference.
No one on this earth knows what will happen next: not Warren Buffett, not Carl Icahn, not Janet Yellen, not even JC Parets (I know, I was disappointed too!). So if there is one thing that we do know, it's that we don't know anything about what will happen tomorrow or any time in the future. Therefore, prior to entering a new position, whether it is a trade or an investment, an exit strategy based on both the best case scenario and the worst case scenario needs to be laid out. We want to know where we're getting out, before we even get in.
Paul Tudor Jones is widely considered to be one of the greatest investors of all time. When asked about this topic, his response was, "Don't focus on making money, focus on protecting what you have". You ever hear the phrase, Defense wins championships? That doesn't just apply to Football, or even baseball, but in the capital markets as well.
Marty Schwartz, one of my favorites, puts it so nicely, "Know your uncle point". Bruce Kovner also says it well, "I know where I'm getting out before I get in". I don't know why some investors are so arrogant to think that they're opinion will always be correct. Just imagine if it's not? What then?
Theoretically, this should be easy to accomplish right? Well it's not. The ability to implement this strategy consistently over time means finding a balance between money at risk and distance from the "uncle point". If you want to have bigger size on and therefore put your stops closer to your entry price, the chances of getting stopped out and whipsawed increase. On the other hand, if you want to give it more room, you then need to have a smaller position size to account for that added risk. No one can tell you where that balance is. You need to decide for yourself.
The way to do that is by first determining who you are as an investor. What are your goals? What is your time horizon? What is your risk tolerance? These answers are different for everybody. I don't like to risk more than 1-2% of the portfolio on any given position. So first I decide how far my entry would be from where I would admit to being wrong. Let's call it $2 per share, for argument sake. Then assume a $10,000 portfolio, just to keep the math simple. In this hypothetical situation, if I want to risk 1% of the portfolio, then I would need to own 50 shares ($10,000 x 1%) / $2]. If I want to risk 2%, then I would buy 100 shares ($10,000 x 2% / $2). This is all regardless of the price of the security. First I figure out the risk, and then I can calculate how many shares I want to buy (or short). Not the other way around.
This is just my personal preference that I picked up from someone along the way during my career. It doesn't mean it's right and it doesn't mean it's for everyone. We all need to decide the size and risk we're willing to put on and take. It's a personal decision.
The point is, I like to know where I'm getting out before I even get in.
I hope this helps
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