As I sit and watch the snow fall over Atlanta, and watch the indices toy with double digit percentage losses for the month, I can’t shake the feeling that things are just not normal. Last week I was out in shirt sleeves throwing the baseball to my son, and a month ago, we were wrapping up a profitable (although only modestly so) year on Wall Street. How quickly things can change!

Prices have been plummeting in good and poor stocks alike and as a trader, it is very easy to become discouraged and extrapolate the current environment into a long-term thesis and expect very few profits out of the coming year. This is a dangerous pattern to get into because it causes apathy and many opportunities will be missed by failing to engage and meet the challenges we face. Conversely, it is easy for other personalities to meet the market weakness with unbridled aggressiveness looking at every lower tick as an opportunity to increase positions in holdings which are already under water. This approach nearly always leads to failure as eventually positions become large enough to wipe out a capital base leaving the trader with no capital from which to make back losses.

So with the uncertainty and turmoil each investor faces this year, I have three principles to share which should lead to strong profits, confident processes, and a quality lifestyle for investors.

1. STICK TO YOUR DISCIPLINE

All investors should have a well thought out written and tested plan.  This plan needs to cover how to handle strongly trending markets (up or down) as well as what do do during times of increasing volatility and uncertainty.  If you do not have such a plan, your investments are likely to to resemble a motor-less ship in the middle of a hurricane.  Any wave has the potential to capsize your vessel, and there is no ability to defensively turn the boat to face danger or to outrun a storm.  If you find yourself today without a written plan, I would suggest liquidating the portfolio to cash and spending the next 3 months reading, studying, and developing a robust approach that accounts for all market environments, bull and bear alike.

It is important to note that there is not a “one size fits all” approach to investing.  The plan should dovetail well with your skills and personality as well as the amount of time you have available to devote to market research and trading.  I have adopted an active management approach within a narrow universe of stocks (public for less than 5 years).  I understand the dynamics that propel prices within these vehicles, and have demonstrated skill in trading the names in this category.  For me to begin to trade Home Depot, General Electric, or Microsoft at this time would be foolish because it does not fit with my skill set, and is not in the written plan which I have committed to follow.

Adam is a very active trader who uses options to capture gains based on the volatility of individual stocks.  His expertise in the dynamics under which these derivatives trade allows him to capture strong returns with little regard to which direction the overall market is heading.  While many would correctly say that derivative instruments can introduce significant risk into a portfolio, Adam has the knowledge and experience to employ strict risk control measures to ensure that his capital base is protected and his ability to continue to produce income is stable.

Another friend of mine, Van, operates on a very different side of this continuum.   Van is a passive index investor (his methodology is passive – he personally is active and thought provoking…) Van pays little attention to daily market swings and looks at lower prices as opportunities.  He correctly surmises that in 2032 when he considers retiring, that this years volatility will have little to do with his long-term net worth.  While I personally have decided to take a different rout to investing, I have tremendous respect for Van and the way he sticks with his plan and blocks out the emotions of the turbulent market.  There is no doubt in my mind that he will be successful in the long-run because of his well thought out plan, and his commitment to following that process.

2. STAY IN THE GAME

Although the turbulent market means that I am hoarding a high level of cash to protect myself, it doesn’t mean that I am twiddling my thumbs waiting for this period to pass.  One must constantly survey the market and be aware of the forces moving prices and trends.  For active traders, watch lists must be updated and information on individual companies should be analyzed.  I have chosen to nibble on some small positions simply to keep myself in the flow of trading so that I do not lose my first-hand sense for how things are moving and the dynamics of the market.  However, I am not willing to risk significant amounts because the extreme volatility has the potential to cripple and drastically cut my ability to profit from the rebounds that will surely come this year.

Apathy can set in if traders are not careful and so making lists of stocks to watch, and analyzing press releases, earnings figures, and analyst reports keeps the mind sharp and the senses alert.  There will certainly be time to make money even on the long side this year, but those situations may require cat-like instincts for active traders.  You do not want to be trying to figure out which stocks are attractive during the two day buying window we may have at the bottom of this swing.  Instead, you should be able to pick out your three best ideas and quickly take positions and monitor the news flow and trading activity within these vehicles.

Even passive investors must stay abreast of the dynamics as re-balancing may need to be considered more often.  With emerging markets separating themselves from correlation to US equities, and commodities prices rising in the face of declining equity prices, it is very possible that a passive diversified portfolio could become lopsided in a short amount of time.  The number one rule of the game is to stick with the discipline, but there is likely more work to be done within each discipline when the market is correcting in this manner.

3. SEPARATE FROM EMOTIONS

One of the best things that happened to my investing process was to take most of the month of November, and all of December with the majority of my capital out of the market.  While that is not possible or profitable to do on a regular basis, I was amazed at the difference in my perspective after spending some time with little capital on the line.  Perspective becomes sharper when one can step back and analyze the entire landscape in one frame.  A sharper perspective is necessary in making efficient, concise, tactical decisions whether you are investing, fighting a war, playing a sport, or even discussing issues with friends.

Trading can be a very emotional experience because success has such a significant effect on ones lifestyle.  The inverse is true as failure in trading can lead to financial difficulty and frustration can spread beyond the analytics to effect what one can and cannot do in life (such as vacations, early retirement, and more).  While these emotions are natural to all of us, suspension of these feelings is paramount to making wise decisions.  The best traders and investors are the ones who can keep their heads, resisting both panic and greed, and consistently make wise decisions.

I have read from more than one respected author that is is difficult to nearly impossible to make wise investing decisions when your personal life is out of balance.  Those going through a job change, difficulty in marriage, sickness of a loved one, or other traumatic experiences should decrease the amount of risk they are willing to take in the market because the skill in decision making is likely to be muted.  While this is not always possible for those of us who are professional investors, it is important to keep the dynamics in mind so that we are not trading according the emotional state we are in.

I hope this post finds you with wise positions in 2008.  All of us are going to make mistakes and suffer losses from time to time.  But it is critical to realize that at any time it is not too late to make wise decisions with what is left.  If you are sinking with excessive losses, do yourself a favor and go to cash for a few weeks to clear your head.  If you are contemplating betting the farm because things are so depressed, be sure to analyze the potential for further erosion and don’t put yourself so much at risk that you cannot recover from a wrong decision.  If you have been successful so far this year, do not get cocky and press your bets.  Instead continue your disciplined approach and shoot for stable consistent gains the rest of the year.

I look forward to the rest of the month, the rest of the quarter, and the incredible potential for 2008.  This has the potential to be an excellent year for any investor who trades rationally, conservatively, and with discipline.  Stay involved and don’t get discouraged!