Do’s: Do plan the trade and trade the plan – My first job straight from university was in a large bank dealing room. Shortly after I started, a new chief trader was hired, imported from the UK to show us “colonials” how to trade. His mantra was “plan the trade and trade the plan”.
To illustrate the point, the chief trader immediately put on a large trade and taped a chart on the wall with his entry point, stop loss level and take profit level clearly marked. It was my job every morning to update the chart with the movement of the day before.
One week later, the hardest part of my job was muffling the sniggers of fellow traders as I updated the chart to show it moving once again through his newly moved stop loss level – and the chief trader still hadn’t cut the position. Two weeks later, he waved the white flag and cut the position for a loss five times his original plan. As you can imagine, the “colonials” never let him live it down.
I’ve never forgotten the lesson. Discipline is essential to minimising losses.
Do manage risk – Again, the scene for this lesson was a bank dealing room. Fresh faced, straight from completing an economics degree at a prestigious university, I was ready to put all of the serious theory I had learned into practise. To my horror, the first job I was given on my first day was to watch a portable television monitor at the end of the trading desk. It was 7.30am and “Mr Ed – The Talking Horse” was on. If Mr Ed put his head down when he first spoke, I was instructed to tell the traders their first trade had to be a “shorting trade”.
If Mr Ed’s head went up, I was to yell out “Buy!” It sounds crazy (hey it was the 1980s), but there was definite method in the madness. The whole process was designed to teach trainee dealers that risk management was the most important aspect of trading. It doesn’t matter what causes you to take a trade (nor what the trade is) – the only thing that ultimately matters is how you manage the trade after you have put it on.
Your risk management principals need to be prudent, appropriate to market volatility and suitable to your emotional and financial capacity to cope with risk. Finding the right balance is not something that can be learnt from textbooks. It’s an art. Having said that, understanding your risk tolerance is a key first step in figuring out what investment or trading style is going to suit you.
Do allow yourself to be wrong – Just like the UK chief trader, too many people can’t allow themselves to be wrong and run their losses way too far. You are going to get trades wrong. Probably more than you get right. Good traders stop their losses on a trade at a predetermined level and move on. There will always be another opportunity around the corner.
Do diversify – Concentrated portfolios are great when everything is going in your favour (it rarely will!) but terrible when things go against you. Professional managers get around the single stock risk by diversification – across stocks, sectors, geographies and asset classes. Don’t have a big portfolio? As little as 20 individual companies can provide significant diversification benefits that lower your total portfolio risk and increase the likelihood of achieving positive risk adjusted returns.
Do have a goal – Know how much you want to make from your investments over the year. This will inform everything else about your trading plan. I see too many clients who are just blindly trying to “make a lot!” This is unrealistic and leads to unreasonable risk being taken. When you know how much you want to make in a year, you can work how much is sensible to risk. You can then bring that down to a weekly or even daily number – or a risk/reward target for each trade.
Don’ts: Don’t get emotional – Don’t fall in love with companies. The market won’t hesitate to take your money off you, so you need to be ruthless in assessing your investments. Stay focused on your plan and investment time horizon. Don’t ever chase losses in a particular stock because you feel like you need redemption…..you won’t get it.
Don’t ignore your costs – Stay focused on your costs to trade or invest – over the long haul these add up. Pick a broker who provides you with the best possible execution and service, but doesn’t charge excessively.
Don’t follow the herd – Mostly (but not always) when everyone is talking about a good idea, that good idea is already priced in to the stock and then some. Value is found where no one else is looking or no one else wants to look. Don’t listen to the noise.