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Tuesday, February 24, 2009

Trading Mistakes (Part 2)

-- Overbetting.

This gets into the realm of money management. Diversification, the process of spreading your investment capital around in different assets and sectors to feather the vagaries of the market, has gotten a bit of a bum rap lately. Some of the New Paradigm folks think the concept is "old fashioned." These tend to be the same people who have every last dime in a handful of internet stocks. That's not investing, or even trading. It's gambling. Preservation of capital is paramount. If you run out of chips, game over man. You may feel a bit envious the day your neighbor, who has put everything he owns into Zowie.com parks his new Mercedes in the driveway next door, but you'll feel a lot better the day the repo man comes with the tow truck to take it back. Most professionals will allocate no more than 2-5% of their total investment capital to any one position. Ten percent should be your absolute max. One more thing. I've checked the U.S. Constitution and the Bill of Rights, and nowhere in either of them does it say that you have to have ALL of your money in the stock market ALL of the time. Money management also pertains to your total investment posture. Even when your analysis is overwhelmingly bullish, it never hurts to have at least some cash on hand, earning its 5% in the money market. You'll need it when you see that next "can't miss" stock but don't want to sell any of your other "can't miss" stocks to raise the money to buy it. Your exposure should be consistent with your overall market analysis. As the market becomes more overbought, overextended, and overvalued, your cash level should rise accordingly. Then as the market gets more oversold and undervalued, you can raise your market exposure accordingly. Being ALL in the market or ALL out of the market sounds like a good idea, and it may work out wonderfully on paper, but it rarely plays out so smoothly in real life and real investing. But you should still employ a sliding scale of exposure, based on your market analysis.

-- Bottom fishing/Catching falling knives.

Many of the daily e-mails I get are of the following type: "Nick, Zowie.com is down 23 points today. Time to buy?!!!" My answer is almost always the same. "Put your pants on, Spartacus. No!" Don't ANTICIPATE bottoms. It's tempting to try to pinpoint an exact low, especially if you're working with indictors like Fibonacci fan and time lines, cycle studies, regression channels, even plain old lateral support points. But it's almost always better to let the stock find its bottom on it's own, and then start to nibble. Just because a stock is down big doesn't mean it can't go down even bigger. In fact, a major multipoint drop is often just the beginning of a larger decline. It's always satisfying to catch an exact low tick, but when it happens it's usually by accident. Let stocks and markets bottom and top on their own and limit your efforts to recognizing the fact "soon enough." Nobody, and I mean nobody, can consistently nail the bottom tick or top tick. Those who try usually get burned.

-- Averaging down.

Don't do it. For one thing, you shouldn't even have the opportunity, because you should have sold that dog before it got to the level where averaging down is tempting. The pros average UP, not down; they got to be pros because they added to winners, not losers. And speaking of averaging UP, there's a right way to do it. And doubling your position is not it. Rather, you should add 1/2 your original stake. If other words, if you already own 100 shares and want to bolster your position, you buy 50 shares. If you later decide to add more, you add 25 shares, etc. Why you should do it this way is too long to go into here, but that's the way the math works out best for you.

-- Shorting bulls and buying bears.

Yes, there are stocks that will go up in bear markets and stocks that will go down in bull markets, but it's usually not worth the effort to hunt for them. The vast majority of stocks, some 80+%, will go with the market flow. And so should you. It doesn't make sense to counter trade the prevailing market trend. If you're worried about a short term pullback, simply cut back on your trading, take a few profits, and build up your stash of cash. Let that money earn its 5% in the money market until the squall has passed.

-- Confusing the company with its stock.

There are some fine companies with mediocre stocks, and some mediocre companies with fine stocks. Try not to confuse the two. This is, at heart, a fundamental analysis versus technical analysis issue. Some stocks simply have excellent trading characteristics while others don't. Maybe it's a matter of liquidity, or a fanatical message board following, or a daytrading clientele, or whatever. Take Amazon.com for example. Is the company a good one? Who knows? Not me. But the stock is. I wouldn't want to have to hold it for 20 years, but I sure don't mind trading it a few days at a time, the "right" days. That sucker moves. Baby Bells are at the other end of the spectrum. Fine companies for the most part. Wouldn't mind owning one for 20 years. But you have to pick your spots when you go to trade them, because a measly 3 point move in a single session is huge for a Baby Bell. Also remember this: even the stock of a great company can go through a bad patch. IBM is a great company today, with its stock selling at 124, and it was a great company five years ago, when its stock was selling at 13.

-- Falling in love with a "story."

This is related to confusing the company with its stock. There are a lot of intriguing "stories" out there, but they don't always translate into instant riches. Iomega was such a "story" stock. The story was that the company's Zip drive was going to replace the floppy in the world's computers. The stock ran straight up to the sky to wait for the story to come true. And for the most part, IOM's story DID come true (many stories don't, witness the Y2K stocks), but the stock gave back most of its gains anyway. Turns out it wasn't that much of a story after all. In other cases, the story comes true but the stock you've bet on isn't the story teller. Witness the laser vision "story." A number of companies were hyped as the category killer, but only one, VISX, made its stockholders real money. And how about satellite communications? Great story, eh? Tell it to those who loaded up on Iridium's stock.

-- Following the leader.

Just as money tends to flow into last year's top mutual fund (sure to be next year's underachiever), people tend to chase the high flying momentum MO-MO stocks, succumbing to the buzz and getting in AFTER the stock has already jumped 80% and inevitably just before it drops 60% as the early buyers take their profits by selling their shares to the "greater fool," you. Yes, you can make a quick buck chasing momentum, but you can lose it even quicker. You can never be sure there's a greater fool coming in after you, and that could make you the "greatest fool."



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