Five rules to help you avoid trading mistakes

 

Trading can be stressful for a lot of people. Whenever you put your hard-earned money at risk, there is always the chance that you could lose.

We all have friends that have struck it rich in the markets, but for every person that finds incredible success there are others who don’t achieve the same results. For many traders, performing as well as the major indices can be considered success. With so much volatility, as so few incredible success stories, it is easy to understand why many people are afraid of the stock market.

In trading, the most important thing to remember is that the best way to find success is to eliminate errors. Each error that a trader makes can be very costly, and erase profits previous profits. If we can simply remove errors from our process, our chances of market-beating results will be much higher.

Let’s look at a couple of common mistakes that a lot of investors make that can be easily corrected.

1. Make a plan
You would be amazed at how many traders make moves without any sort of long-term plan. If you do not have a specific plan for your investing then you are operating in the dark. You need to have two types of plans. The first is a long term plan. What is your ultimate goal? Do you want slow and steady gains, or are you looking to take on as much risk as possible in order to try to make the big score? Once you determine your long-term objectives, you can tailor specific trades or strategies to accomplish the goal. You also need trade-specific goals. Before you buy a stock, ask yourself what you want to get out of it. Do you want years and years of steady dividends? Perhaps you want a quick 10% gain. If you know ahead of time what you want, it makes your exit strategy a lot easier to formulate. Trading without a plan is no different than a professional football team taking the field without a game plan. It is a sure recipe for failure.

2. Have an exit strategy
There is an old saying in investing that says: “buying stocks is the easy part, knowing when to sell is the hard part.” A lot of beginning traders spend hours upon hours researching and screening stocks to buy, but once they make the buy they stop working. This is a HUGE mistake. You need to know exactly how you plan to get out of the trade. Once you buy a stock, you can set up stop-loss orders to limit your downside risk, and you can also put in sell orders at your target profit point. This way, you know exactly what to do should the market move against you, or in your direction. Too many traders put stocks into their portfolios and then watch the values each day, with no clear understanding of what actions to take next. Having an exit strategy is a great way to remove this mistake from your trading.

3. Use indices to your advantage
This rule is especially true for beginner traders, but is important for traders of all levels. You do not want to keep all your assets in stocks. Even the best traders in the world make mistakes, and chances are, you not among the best traders. The more inexperienced you are, the higher percentage of assets you should keep in index funds. For someone starting out, it would be wise to keep 60% or so in index funds just to make sure that you have a sizable amount of your assets keeping up with the overall market. Over time, the indices trend higher, so you will earn a profit on your index-fund holdings, but it will be slow and steady. Low-cost index funds give you diversification, and allow you to benefit in an up market without having to take on too much risk. Keep a portion of your money aside to play with in stocks to help you learn, but the more risk you can remove from your trading the better.

4. Don’t follow the herd
This one is hard to follow. Even I often find myself itching to jump into the current “hot stock”. Unfortunately, by the time the herd makes its move it is usually too late, and you will wind up on the losing end of the trend. Every now and then there is super-hot stock that everyone is talking about. Maybe the stock has traded up 25% over the last month, and is currently setting an all-time high. You read news reports, and watch the talking heads on CNBC talk about how great the stock is, and how everyone is making so much money on the stock. Remember this… when everyone is saying to buy a stock, that is typically when the smart money starts to unwind their positions. Stick to your plan, and never let the mania around a certain stock make you deviate from your plan.

5. Keep emotion out of it
Emotion is a tough one to combat. Perhaps we buy a stock and it performs well for the first month. Then all of a sudden there is a bad earnings report, or some other negative news that puts the stock in a downwards trend. Quickly we see our previous gains erased and our position move into negative territory. If we are using our brains, we know that things are not looking good and we will sell at a small loss and look for our next play. However, if we let emotion get involved, we tell ourselves that the stock has to come back, it was strong before, so it will be strong again. We hold onto our shares and slowly but surely we lose more. We form emotional connections with our stocks, and that can be very dangerous. This goes back to our second lesson about having a predefined exit strategy. Having exit trades working at all times is a big step towards taking emotion out of your trades.

Michael Fowlkes

Michael Fowlkes

Michael Fowlkes is a financial writer who has been with the Fresh Brewed Media family since 2004. Over the course of his tenure with Fresh Brewed Media, he has worn many hats, including portfolio manager, options analyst, and writer. Michael received his undergraduate degree from Virginia Tech in Accounting and got his start in finance working as a stock trader for six years at Chase Investment Counsel in Charlottesville, Va.

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