The Easiest Lesson of Successful Investing

B.P. – a subscriber of ours – just got burned in the markets...

In just one stock, "I have lost almost $13,000," he told us via e-mail. "I have now been stung, and I learned my lesson."

The reality is, he already knew the lesson. He just didn't apply it.

He knew he wasn't following "the rules." He knew a loss of that size was his own mistake. He told us in his e-mail that his loss "validates your constant reminder to [follow the easiest lesson of successful investing]."

Losing $13,000 in one stock did it for B.P. He told us the easiest lesson of successful investing "is now burned in my brain, and I will always be careful."

Today, I'll share with you the lesson that B.P. chose to ignore...

I've got to warn you though, for some reason, the easiest lesson of successful investing seems to be the hardest to apply...

There's a funny thing about it. When I share it with someone who has never invested before, they understand it immediately. It makes total sense.

But when someone is emotionally connected to his investments, he often fights it. He can't seem to follow through. And then he loses money. Sometimes, he loses a lot of money, before he finally "burns it in his brain," as B.P. said. Some people are so stubborn, they keep on losing money.

Mark Twain's famous quote applies here... "If at first you don't succeed, try, try again... But then give up. There's no sense in being a damn fool about it."

The easiest lesson is incredibly simple... Keep your losers smaller than your winners.

Most people sell their winning positions once they see a small profit – maybe 20%. But most people don't sell their losers, meaning their downside risk is 100%. Therefore, most people invest with 20% upside potential and 100% downside risk. Those are not good odds!

Said another way, their "reward-to-risk ratio" is 1 to 5. You've got to turn this around. You need to get your reward-to-risk ratio up to around 3 to 1. So how do you do it?

Well, first you need to limit your downside risk... Tell yourself you won't lose more than 25% on any stock, for example. There's nothing magical or special about 25%... it's having a plan and the discipline to stick to it that counts.

If you want to have a reward-to-risk ratio of 3-to-1, like I recommend, then you can't invest in anything that can't make you at least 75%.

So the second thing you need to do is let your winners run... Quit "cutting" your winners as soon as you see a 20% profit. Instead, change your mindset entirely... let your winners run!

For example, right now, subscribers to my letter Sjuggerud Confidential are sitting on gains of 700% in Seabridge Gold. Look, you make your big money in stocks by having a few really big winners like this. If you had "cut" this winner as soon as you'd made 20%, you would have missed out on all those profits!

Think of it like poker... Poker is not about the cards... it's about managing your bets. You have to fold a lot in poker – you have to lose a lot – to win in the long run. But you're managing your money... you're cutting your losses early.

B.P. knew these rules. He knew that the way to make money is to limit your losers and let your winners ride. But he didn't do it. He told us "I lost almost $13,000 on American Home Mortgage... because I did not sell when I reached my 25% stop loss. I have now been stung and I learned my lesson. This validates your constant reminder to set a mental stop loss and apply it."

Don't worry B.P. I'm sorry to hear about your loss. What you just did was simply "pay your tuition." Often, we have to have a painful experience before we really hold onto this kind of stuff. You never know what your tuition fee will be in advance, before you finally take the lesson to heart.

Good investing,

Steve

P.S. In addition to getting out there and making a few mistakes, reading about the world's greatest investors is one of the quickest ways to becoming a successful investor. You can learn about several of my favorite books here.

P.P.S. A neat little program to help you track your stop losses is TradeStops. It was developed by Richard Smith, a True Wealth reader with a PhD in math. He's created a simple, Internet-based investment tool that tracks stops and even sends an e-mail when one is hit. I use it myself.