Stocks are one financial subject that seemingly everyone knows something about. While there is a low barrier to entry associated with investing in stocks, as opposed to commodities or options, many investors make the same common mistakes that sabotage their portfolios. This is why many investors are better off investing in index funds. If you do choose to invest in individual stocks, you need to be aware of these common errors and learn to invest using a systematic methodology that leverages best practices and lessons learned.
Risk management is an important tool that can be utilized to understand, assess and control risks associated with investing in the stock market. The other side of the risk management coin is opportunity management. The focus of this site is on risk and opportunity management. While traditional risk management focuses on potential adverse effects, it is important to also consider the other variable when risking capital, known as opportunity management. This is the reward that results from a given speculation. It is critical that both risk and opportunity be considered when analyzing a potential investment or loan.
Some of the more common mistakes that stock investors make include the following:
1. Lack of diversification: Investors who put all their eggs in the same basket will learn sooner or later that this is a risky venture. For example, investors who backed up the truck with Internet stocks in 2000 and again with home and mortgage related stocks, quickly learned a hard lesson.
2. Continuing to average down on a single position: Professional investors refer to this as “catching a falling knife” for good reason. Buying a position on the way down is referred to as “averaging down” because it lowers the average price of the stock your buying. Pursuing this strategy by blindly buying as a stock plummets down can be a good way to destroy your portfolio. Stocks that are moving down rapidly are typically being moved by professional or “smart” money.
On the flip side of these common mistakes are some of the following winning strategies:
1. Let winners run: Be a Student of winners and if you pick a winner don’t be afraid to let it keep going up. Every stock will have temporary sell-offs on the way up. While it may be prudent to sell off part of your position if you have large gains, give your stock some room to run. A good strategy is to use what is known as a “trailing stop loss”. This type of sell order gives your stock room to go up and will only trigger a sell if your particular conditions is met i.e. if you have a 10% trailing stop loss, the stock will sell if and only if your stock is down 10%. If instead your stock goes up, you still own the stock!
2. The trend is your friend:This is one of the most common sayings on Wall Street but its inherent wisdom is may seem counterintuitive to soon. Stocks have momentum and often this momentum can become a self-fulfilling prophecy: stocks that go up attract attention and new buyers and tend to keep going up, while stocks that are not performing well cause selling which can also gain momentum.
3. Cut your losses: You should have a maximum loss percentage that you are willing to accept before purchasing a stock. For example, consolidate before purchasing a stock you should decide how much your willing to lose. If you choose 20% for example, you should stick to your plan and sell the stock if it reaches this point. This is often easier said than done, however, as emotions can get in the way and cloud your judgment.