Protecting Your Mental Capital

As traders we think in terms of gains and losses, the monetary end of the game. Is my account equity more than it was last month, quarter, year? Often however we overlook our "mental capital". Trading well requires a high level of confidence and discipline. If you aren't confident in your strategy, you will not have the discipline to execute the signals without letting your emotions interfere. This is very important. We need to protect our mental or emotional capital to have lasting success in the market.

I had a tough week in the markets. Our Large-Cap portfolio did just fine, it was my Growth Portfolio that took a beating. I don't often discuss my Growth Portfolio on the blog, but this week I need to work through some things.

Growth stocks have inherently more volatility than the Blue-Chip companies. The increased volatility is especially exaggerated on earnings announcements. This week I had negative reactions in FB, RDN, ICLR, HAR, and TYPE. Those stocks made up roughly half of my growth portfolio. ICLR dropped -10% on Tuesday, HAR initially fell -16% Thursday morning but closed down -8%, and TYPE dropped 15% on Friday closing at the lows. Roughly 1/3 of my portfolio dropped over 10% this week. I don't care who you are, you feel the cumulative effect of those beatings.

Despite the emotions involved with the heightened volatility this week, I executed my plan and took the exit signals when they presented themselves.

Volatility happens in the stock market, it impacts our individual positions and overall account equity. When we are losing money it can be painful, both financially AND emotionally. This is why eliminating losing trades quickly is so vital to our survival in the markets. Nobody likes to be wrong, especially when being wrong costs money. But letting a small manageable loss turn into a huge loss can be more damaging than just on a monetary level.

To trade our best and to execute our systems properly we need to be confident in our ability to read the market signals. Big open losses can alter the way we view things and exaggerate our bias.

It is imperative that we stick to our predetermined plans for all trades we enter. These "plans" made in a clear/rational mindset are in place to make sure our losses stay small and within our risk boundaries. When a position gaps against you it is most important to continue to execute your plan despite the rapid change of character.

Getting stuck in a large losing trade not only ties up capital that could be used for buying new market leaders, but it creates a drag on our emotions. The natural reactions to these events are: "it will come back", or "I'll just hold on until I'm even", or even worse "its cheap, I'll buy some more".

If you react this way and change your plan after the fact, you set yourself up for a massive downward spiral. Keeping your emotional capital intact is one of the most important aspects of successful investing. Shedding losses early allows you to move forward with a clear head and approach the next opportunity from a position of strength. If you allow that loss to fester and grow, your account will continue to under perform and you will become emotionally attached to your losing trade. 

By cutting my losses quickly this week and continuing to run my winning positions, my Portfolio only suffered a -2% drawdown overall. Considering TYPE had the worst trading day ever in its history Friday and half of my holdings had negative reactions, I feel like I got out relatively unscathed.

This has been the most ruthless earnings season I can remember in the last 5 years. My strategy was able to withstand quite a lot and came out the other side ready with new cash to deploy into the next potential market leaders.

I followed my plan and have been able to preserve my mental capital.

--Our Lg-Cap Portfolio had no exits this week and we will be adding two new holdings. We discussed last week how we parted ways with a few lagging positions so if new opportunities presented themselves we would be able to act on them. Well we in fact had new signals emerge in GILD and AIG. Lets take a look:

Entering Gilead Sciences (GILD)

Gilead has been on our watchlist recently and this week gave us our signal to enter. In a market environment that has been slaughtering companies on the announcement of their earnings reports, GILD rallied 4.5% on Friday after posting another strong quarter.

Price has made new 10-week and 50-Day highs, with long-term moving averages stacked and rising. Our indicators suggest that the long-term trend is intact and may now be resuming after a 9 month consolidation. 

Our initial stops will be placed at 97.70, below the swing low and where the 50 WMA is sitting. 

Entering AIG (AIG)

AIG appears poised to resume higher after a year long consolidation. They announced earnings late last week and posted a strong quarter. Most importantly the reaction to the report was positive, confirming the recent breakout with a higher weekly closing high.

Our indicators are in the preferred posture and initial stops will be placed below the $54 swing low.

Trailing stops tested

We had three holdings come down to test our trailing stop levels. Fortunately Friday's bounce helped all three hold above those levels.


UNH

BA

FB

By most metrics I use, the market appears destined to resume higher. Prior leading stocks are now testing support levels while breadth continues to improve. The rotation into Energy names recently has strengthened the underlying trend for the SP500, and it has also allowed some of the leading stocks a chance to consolidate. If the market wants to push higher I feel it is about to do so very soon. Either we see a push through new highs or we will see major rollovers in many of the leaders of this bull market.

The next few weeks will tell us a lot. Good Luck!