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A Hedge Fund Mistake Only Rookies Should Make

Posted October 08, 2021

Zach Scheidt

By Zach Scheidt

A Hedge Fund Mistake Only Rookies Should Make

“Zach, tell me why you bought this stock…”

I could tell Bill wasn’t happy about something.

Bill was my boss and mentor at the hedge fund I used to work at. After a year of researching other managers, Bill graciously gave me a small piece of our fund to manage.

This was his way of testing me out to see if I had what it took to be a hedge fund manager.

(By the way, I completely failed at my first attempt. I’ll tell you about that frustrating day another time.)

Each week, Bill and I would sit down and look through my investments and Bill would give me feedback… This week Bill was asking about a tech stock I had been holding for a while.

I quickly explained that the company had been on my watchlist. I reminded Bill that I purchased the stock when shares broke above a key level.

And secretly, I was a little frustrated that Bill didn’t remember we had spoken about this position the previous week when he asked a similar question.

That’s when Bill looked up at me… smiled… and I could tell he had another good lesson for me.

Plan Your Trade and Trade Your Plan

“Ok Zach, when you first bought this position, you were excited about the stock’s breakout. But what happened next?”

I explained that the stock had stalled out and pulled back. Which obviously wasn’t what I expected when I first bought the position…

But the company still had some great intellectual property. I liked the management team. The stock was on several brokerages’ buy lists. And I was confident the position would rebound in time.

“So you watched this stock for a long time…”

Bill was being patient with me, but I was starting to get irritated.

“And then you bought because it traded higher. Because it had momentum…”

Yep, clearly Bill understood why I originally bought the stock.

“But then the momentum failed. And your original reason for buying disappeared.”

That’s when the light switch flipped in my brain and I saw what he was getting at. Bill explained that when you make a trade or an investment, you should always have a plan.

At a bare minimum, that plan should include:

  • Why you’re entering the position.
  • What you expect to happen.
  • And how you plan to exit (win or lose).

And the most important thing is to stick with the plan for as long as you hold the position.

I made the rookie hedge fund trader mistake of changing my plan mid-trade so that I didn’t have to close out the trade for a loss.

In the hedge fund business, no one gets it right all the time.

But as Bill always said — literally several times a week:

“It’s alright to be wrong… but it’s not alright to stay wrong.”

It’s a lesson that has stuck with me throughout my investment career. And a pretty good life lesson as well!

Don’t Make Excuses for a Trade Gone Sideways

Bill’s words are especially timely in today’s market environment.

As many of the most popular stocks on Wall Street head lower, I’ve heard many traders tell me that they now consider themselves “long-term investors.”

What changed?

Well, that short-term trade they hoped would make a fast buck went south.

And now they’re stuck holding a stock that is underwater.

From Bill’s perspective, these traders are committing the cardinal hedge fund sin! They’re changing their strategy mid-trade.

So now instead of making a short-term trade, they’ve decided to become long-term investors.

Standing on the outside, it’s easy to see that this is really just making an excuse to avoid taking a loss. Because there’s something painful about closing out a position that didn’t work the way you expected.

Human nature would rather hold that position until it comes back.

And unfortunately, that often means missing out on some other great opportunities because your capital is tied up in an “investment” that is taking way longer than expected to pay off.

How to Get Out of a Hedge Fund Blunder

If you’ve made this mistake and you’re stuck in a trade (or investment), don’t feel bad. You’re certainly not alone.

But don’t stick your head in the sand and ignore what’s happening.

Remember Bill’s words of wisdom: It’s alright to be wrong… but it’s not alright to stay wrong!

The first thing I would do is to close the position immediately. That’s right, just sell it — at whatever price the market gives you.

Remember, you can always get back in if you want to.

That’s the beauty of markets. They’ll always be around, and there will be new opportunities every week.

But the clarity you’ll get from closing that losing position will surprise you!

Stepping back from the situation, looking at the stock from a more objective position, and then deciding where to invest your capital from a starting point will help you make a much wiser (and likely more profitable) decision.

Believe me, I know… I’ve been there more times than I care to admit!

So if the weakness in our current market has you feeling trapped and paralyzed, consider clearing your slate and starting from scratch. You might wind up with an entirely new roster of winning stocks!

If so, send me a tweet and let me know how you did!

Here's to living a Rich Retirement,

Zach Scheidt

Zach Scheidt
Editor, Rich Retirement Letter

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