Friday, August 21, 2009

Trading, Investing, and Trauma

Proper risk management is not only a cornerstone of good trading and investment; it is essential to trading and investment psychology.

When traders and investors are exposed to excessive risk, the magnitudes of the gains and losses generate large emotional swings, which then interfere with sound planning and judgment.

This is a common challenge for traders looking to increase their size: they bump up their risk in a large increment and then have difficulty emotionally weathering the larger P/L swings.

It is also a common challenge for investors, particularly those who were "all in" the stock market during the 2008-2009 collapse and now also face declines in their home values. The impact of such losses can be traumatizing, making it difficult to later take normal, prudent risk.

Jon Markman recently interviewed me on this topic and put together an excellent article for the MSN Money site. His point is well taken: many individual and professional traders and investors have been left behind in the recent rally because of their lingering fears from prior losses.

It is the nature of trauma to leave us forever fighting the last battle. That leaves us vulnerable in markets when the battlefield changes. Sound risk management is the best therapy of all, because it is preventive. When others are traumatized, the prudent risk taker can be poised to seize opportunities.