The following was written by a colleague...one of the top professional traders in the country.
The Ten Mistakes That Beginning Traders Make
1. Trading Without a Plan – Too many traders start trading without a well-defined methodology. Whether it is a black-box mechanical system, or a well thought-out discretionary tactic, every trader needs a consistent approach to the market. The approach needs to include precise entry and exit points, and risk management practices.
2. Setting Unrealistic Expectations – Beginners think that they can make a living through trading with a small initial investment. They think that they can double, triple, even quadruple their accounts in a year. The setting of irrational expectations is a precursor to failure. The best professional money managers in the world average 20, or maybe 25, percent per year.
3. Impatience Leading to Overtrading – There is a notion among amateur traders that they must be in the market at all times. This leads to unnecessary taking of risk and poor decisions. The fact is, sometimes there isn’t a good trade to be had. Furthermore, the overtrading that stems from impatience leads to an insurmountable mountain of transaction costs in the form of commissions. Transaction costs eat into profits and should be minimized.
4. Improper Position Sizing – In an attempt to achieve the aforementioned unrealistic expectations, new traders take on far too large of positions. Risking upwards of 20, 30, even 50 percent of account equity per trade, these traders quickly learn about the law of probabilities. In all reality, position sizes should be kept in check. New traders should start by risking no more than one or two percent of account equity in any given position.
5. Lack of Diversification – Industry groups come into and go out of favor. It’s a simple truth of the market: rotation. New traders too often get caught up in the hysteria when a certain sector is out performing the market, and focus far too much of their capital on that group of stocks. Eventually the trend comes to an end, and beginning traders are often caught with a concentration of these stocks. The only defense is diversification, which also mitigates many other risks.
6. Poor Risk Management – Proper position sizing and diversification are parts of an overall risk management plan. Unfortunately beginning traders don’t even consider risk as a part of the investing equation. These traders are overly focused on the reward side of the equation, which exposes them to excessive risk-taking. In addition to properly sizing positions and diversifying, traders need to account for other risks such as interest rates, politics, exchange rates, and competition. This is achieved through taking the time to research individual positions.
7. Trying to Time Tops and Bottoms – Amateur traders look at charts of stocks that have risen three-, four-, even ten-fold and feel that they have missed the boat. This feeling compels them to try to pick the end of the trend, and adopt a bearish stance. The same feeling occurs when a stock has dropped by 50 percent, or more. The new trader thinks that the stock has fallen enough, and is compelled to buy. The truth is that tops and bottoms take time to form, and trying to accurately predict the end of a trend is nearly impossible. It is, in fact, this attempt to predict that perpetuates trends.
8. Trading Against the Trend – Whether it is a subjective observation of higher highs and higher lows, or an objective definition using technical indicators, it is paramount that traders identify and trade with the trend. Too many new traders struggle against the market, forcing their will onto a stock. When in all reality, the task is rather simple: Identify a trend and go with it.
9. Focusing on Being Right – There is a chasm between being right and making money. The latter involves knowing how to be wrong, knowing how to lose. The game of investing is one of probabilities. Amateur traders never consider the possibility of being wrong. They think that they must make money on every trade. This is a fallacy. Knowing how to lose opens the door to making money in the market.
10. Cutting Profits Short, Letting Losses Run – There are two basic human emotions in the market: hope and fear. Forget about greed. Hope and fear drive decisions which, in turn, drive stock prices. Unfortunately, these two emotions work against beginning traders in the market. They get hopeful and fearful at exactly the wrong times. New traders turn fearful of losing a profit once a position shows a small gain. Consequently, they cut profits short. On the other side, amateur traders turn to hope when a position shows a loss shortly after entry. This hope leads to bigger and bigger losses. The trick is to reverse the emotions: Be hopeful for bigger profits and fearful of bigger losses. This is achieved by having a well-defined methodology, using proper position sizing and diversification, managing risk, being patient, and trading with the trend.
Full Credit goes to Eric Utley
2007
