Seven Stupid Mistakes that Smart Investors Make
By Alan Knuckman, BullsEyeOption.com
Learn from some of the common mistakes that Smart investors make:
#1: Inability to Focus on Financial Exposure…A Gambler’s Mentality
Quantifying actual dollar risk is the primary, almost single-minded objective for professional investors. They understand the importance of putting probability in their favor while limiting downside exposure.
It is logical to evaluate the worst-case scenario first and determine whether to investigate the opportunity further. Think first about the effect of the investment loss on the account. (The negative mental impact may be great as well, and very difficult to overcome for future opportunities to make money.)
Many market participants, unfortunately, focus primarily on potential profit to their own peril. It is far too common to identify plays that could make $500, $1000 or any potential profit when a specific downside dollar risk amount has NOT been predetermined.
Go into a trade expecting the best, but planning for the worst. Make risk control the primary focus.
The “All In” gambler’s mentality is destructive and an unbalanced trade-off between profit and unlimited loss exposure. Always know your RISK and what that potential downside would mean to the future of your investments.
Only a solid plan has analyzed the reward-to-risk ratio to be sure it is a worthwhile investment of time and treasure. If you know what you are risking today, you can be sure that you are able to invest tomorrow and the tomorrows’ after that.
#2: Let Short-Term Events Impact a Long-Term Investment Plan
Market Volatility (which is price movement … and therefore opportunity), has paralyzed investors. The information onslaught makes it difficult to decipher the data for use.
The financial channels and internet provide more financial information than ever to individual investors. The result is NOT better decision making but unfounded immediate emotional reactions to daily events without thinking long term.
Don’t watch Financial TV!! As a frequent contributor on a major network daily, I am increasingly aware that most of the content is nonsense, infotainment designed to keep you tuned in and pay for the advertisers.
KEY EXCEPTION
www.BullsEyeOption.com has two daily video market commentaries that talk about what has happened the previous session and what is moving markets in the morning.
My “Morning Market Stir” video is an early update from the CME group on action in the commodities building blocks that impact all markets. The CBOEtv “Pre Market Pulse” is a summary of stock market action with an emphasis on stock options.
Otherwise the CNBC type “can’t-miss” oil inventory release only heightens anxiety and emotion. It is not very often that a good investment idea is mentioned with risk parameters. The markets are where they are based on the news, but that does not tell us where they are going.
An earthquake, weekly jobless claim number, or stock quarterly earnings miss by a penny should not change an investment approach designed for retirement. Short-term timing for money that is not needed for decades is a fool’s errand. (If you don’t know who the patsy is, it may be you.)
Long-term paths to success should be evaluated on a monthly or even quarterly basis to ensure investment plans are on course.
#3: Inability to Eliminate Personal Ideology and Opinions from Trading
Many wasted hours have been spent staring at market quotes on the computer screen without any positive impact on direction.
Often times, the conviction to a trade make it more difficult to objectively analyze and follow the plan accordingly. Hope that things go your way is NOT and investment strategy that can be counted on for results.
Investors are capitalists first. The markets do not care about any political affiliation, and neither should you. A desire to see one party triumph over another does not change the economic score that determines winners and losers. Many bearish investors have been gutted by “the Bull’s horns” over the last six years’ uptrend with intermittent market declines.
Government debt, unemployment, housing numbers, recession worries, etc… are all concerns for investors but not unforeseen influences that HAVE TO move the market a certain way. If it was that easy, it would be that easy.
Predicting an upcoming economic event outcome DOES NOT make money, determining the how the markets will act is what pays.
The S&P 500 Index has risen 200%+, 1500 points, from the 2009 extreme lows. That is a FACT and not an opinion that has been very expensive to anybody that might disagree on trend direction.
Though the market may go down from here, anything can happen, it is important to recognize that wanting and believing that something must happen can be expensive and does not make it true.
#4: Poor Allocation of Funds and Incorrect Portfolio Diversification
Another simple mistake is to invest a constant amount of 200 shares or 5 option contracts regardless of price. This can put an unintended disproportionate amount of money at risk for the expensive investments.
The smaller dollar plays on a $10 stock may not offset potential losses in $75 stock if each trade is a mistakenly constant 100 shares.
Break the account into EQUAL pieces to ensure that each investment has the same weight and has a proportionate impact on the whole.
A common method is to divide the capital by twenty to make each investment no more than 5% of the portfolio. This way, if any single investment has the maximum loss and drops to zero, you still have 95% of your portfolio intact.
5 Percent Rule
Another issue is the separation of long-term funds from speculative investments. More aggressive tactics may be appropriate with “mad money” than index mutual funds designed to reflect the stock market appreciation over the next twenty years.
It is often better to have separate accounts to divide the funds physically that have different mindsets.
Diversification is necessary to hedge and protect through many investment classes and vehicles.
Stocks, bonds, indexes, commodities and currencies can all play a role in the portfolio but the cumulative net impact should not jeopardize the whole basket at the expense of any one investment.
#5: Not Taking a Loss, or “Letting a Trade Become an Investment”
The undisciplined investor is known to say that an investment is a short-term trade that did not work. Learning to take a loss is an invaluable lesson that often takes years to master and appreciate.
If a trading plan does not produce desired financial results, taking the loss is mandatory. End of story, move on and leave it behind you.
Being right only a little more often than you are wrong, combined with proper money management, produces the desired successful results.
Professional traders can do fantastically well with only a 60% profitability rate knowing that they kept the losses small and reasonable.
The need “to be right” can overwhelm a novice trader. When your mental capacity to see and act on opportunity is diminished by obsession with a losing trade, this often leads to large losses and unnecessarily ties up dollars.
Once you are out of a trade according to the risk control plan, it is easier to evaluate market opportunities with a clear head.
No one trade should have catastrophic results and never does if that first loss results in the intended exit. Think of it as a pilot in the air wishing he was safely on the ground versus the opposite.
#6: Failure to Set Attainable and Realistic Financial Goals
Low return yields have become the new normal after the global financial crisis. Double-digit yearly stock market gains for the major indexes seem few and far between. The globalization of the financial world has made investing opportunities accessible yet more challenging than ever before.
This quest for immediate results has shortened business lifecycles and trends to the detriment of long-term investing. The days of buying shares of a “good” company and opening the safety deposit box years later to sell for profit have long since passed. The advances in technology and efficiency force us to trade, not invest (fail to plan, plan to fail).
A trader is an investor who has a strategy for entry, risk and exit. Each and every trade can be broken down into four major parts of:
• Identify
• Execute
• Manage
• Maximize
A disciplined trading plan can be utilized for both short- and long-term profitability. Just repeat as necessary.
The analysis of annualized trading returns can quickly determine how long it will take at that rate to double the portfolio. The rule of 72 (divide 72 by the annual rate) shows the power of seemingly small and achievable results to build funds. A conservative 7% return doubles the account every decade.
#7: Not Determining Your Risk Profile or What Type of Trader You Are
Timing, not Time Frame, is the key to investment success.
Lifestyle and investment personality have more to do with what type of trades fit your profile than anything else. A longer trade time frame often means the investment is less sensitive to current events.
All trading needs to be disciplined, with key decision choices less frequent and immediate for the 3-6 month horizon or longer versus a sometimes frantic day trader.
There are multiple right ways to trade using many investment choices. The HOW is much more important than WHAT you trade.
The stock or option trader also has to determine what time frame is appropriate for risk tolerance to ensure trading plan longevity. The markets offer a remarkable opportunity for anyone and everyone to profit and are a marathon, not a sprint.
Very simply, the only way to determine your personal trading style comfort is to live it. If you have limited time and can only participate nights and weekends, ultimately find weekly/monthly opportunities.
Though your schedule may allow you to trade throughout the day, it may not fit your personality. You will quickly know what does and does not work for you and must adapt the variables of time, money, and investment markets to fit your individual needs.
Seem simple?
A lot of it is…on paper.
The hardest part of all is having the discipline to do it each and every trading day.
Sometimes, it’s better to have someone helping you as you get started… a pro to ask questions of, a shoulder to look over.
THE MOVIE
Click Here to watch: “Five SMART Things Investors Have Wrong About Options”
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ABOUT THE AUTHOR
Alan Knuckman started his career at the Chicago Board of Trade as runner/clerk, then moved his way to trading futures and futures options in the Treasury pits.
With strong broadcast media skills in analyzing the markets, Alan is a frequent expert for major news organizations where he appears regularly on CNBC, Bloomberg TV, Fox Business Network, CNN, Sky Business News in Australia.