Diversify, Diversify, Diversify
Diversification, even in trading, is very important for risk
reduction. Since you aren't going to be correct in every trade
you make, diversification is necessary and important as a means
to risk reduction and capital preservation.
The simple fact is this: if you put all your trading capital in
one or a very limited number of stocks, you are just asking for
trouble and increasing the risk you are exposing your money to.
At some point, if you trade long enough, you will undergo owning
a stock that drops like a rock for one reason or another. Most
people who have traded for any length of time have been there,
and it's no fun at all. Avoiding putting all of your eggs in one
basket is the first step in limiting risk when it comes to both
investing and trading.
It is important to avoid investing too much in a position. There
is an old story on Wall Street where one trader asks another
trader for advice. He says, "I've bought so much of this stock
that I can't get any sleep at night... what should I do?" His
friend says, "Reduce your position in the stock down to the
sleeping point." This is not only very good advice, but very
true. The smart trader takes up no position in such large
quantities that it makes him overly nervous or subjects him to
loss of sleep.
Trade at levels which you can afford, and you will generally
feel much more comfortable in your trading. This will generally
result in much clearer thinking and smarter decisions on your
part. Too much risk will result in too much fear, and that will
cloud your thinking and judgment.
Trade stocks that you know. Part of being confident about a
position you take up relates to having some understanding of the
company behind the stock. Clearly it is impossible to know every
little detail about the day-to-day operation of every business
you buy stock in. However, it does help if you have a basic
understanding of the type of business they are in and how news
(positive or negative) may relate to and/or impact a company and
their stock. This will not only help you feel more comfortable
about the position you take up, but it will allow you to more
quickly evaluate news which may be released regarding the
company. Trade stocks you know or that are in areas you may have
experience in. Warren Buffett is a good example of this
philosophy. He has no problem telling share holders in his
investment companies that he doesn't understand much about
technology related companies and therefore steers clear of
buying such stocks. Sticking to what you know is not only a good
way to start out investing and trading stocks, but it can help
you feel more confident and make better decisions along the way.
Another approach is to trade popular/liquid stocks. Stocks that
are "popular" with the public and investment community have a
very real benefit to your trading. Specifically, they tend to be
very liquid. Liquidity is a measure of how much volume changes
hands on a specific stock (typically on a daily basis). The more
liquid the stock is (i.e. the more shares it trades) the more
likely you'll get a fair price when buying or selling the stock.
Also, the more likely it is that there will be a market to buy
from or sell into.
Trading stocks which have very low volume (typically under
100,000 shares per day) can incur additional costs and can limit
your ability to get in and out quickly when so desired. Often
times if you try to buy or sell a large block of stock, there
simply won't be a market at current prices. This can result in
the market "stepping away" from you when you go to sell. Worse
yet, you can drive the price up on yourself. While there are
times when buying a little known stock may work out, for most of
your trading, you should strongly consider sticking to actively
traded stocks. This is true of options trading as well (i.e.
stick to options on stocks which trade higher volume).
Trade stocks that are making money. The stock market is based
largely on economics and business (with some emotion and
perception thrown in). As a result, I personally feel it's a
good idea to trade stocks on companies which are currently
showing a profit, as opposed to companies which "might show a
profit someday". Great ideas are a dime a dozen, as they say,
and you don't have to look far on Wall Street to find stock in
companies that are using other peoples' money to test out their
"great" idea. In my personal opinion, I would much rather be
trading stocks in companies that are currently profitable.
Additionally, keep in mind that even companies that are "making
money" on the top line may not be "profitable" from a net
(bottom line) profit standpoint. There are many companies out
there that have racked up a tremendous amount of debt and/or
have business models that, while they bring in quite a bit of
cash, are unable to actually show a profit at the end of the
year. Generally speaking, stocks which are currently showing a
profit or are very close and very likely to show a profit in the
near term, trade better and are somewhat less risky than stocks
which are either in the red or struggling to show profits on
their financial statements. Part of this is because valuations
are much easier to calculate from real earnings (i.e. using the
company's P/E ratio) than trying to base valuations on "what
might happen" down the road. True, sometimes stocks trade more
actively or more wildly on news of potential profits, but at the
same time, when a company announces they may not meet analysts'
expectations or may experience an earnings short fall, it can
get quite dangerous. Consider sticking to companies with
tangible, consistent earnings when doing your trading as a
further means to risk reduction.
Finally, avoid buying the "Big Event." This idea tends to go
hand in hand with the ideas presented above (regarding trading
companies that actually are able to show a profit). In the stock
market, there is always "some big event" that might take place
for a company or the market. Buying or selling based on the
possibility that this event may take place (or may not take
place) or based on the how the market might react to such an
event tends to turn your trading into a gamble more than
anything else - and this is very risky.
Buying a stock ahead of what might be a "big event" can be quite
risky and often times tends to delay your trading. Very often
these big events (such as mergers, buyouts, etc.) get delayed
for months and months. If you wish to hold a stock for weeks and
weeks or months and months waiting for some big news flash, then
that's perfectly okay. However, just keep in mind that generally
stocks move up on news far before the average individual hears
about even the rumor of the news. As a result, you often see
stocks trade down on positive news (due to the fact that the
news was already anticipated long in advance and largely priced
into the stock prior to the release of the actual news).
Generally speaking, buying the big event will tend to be not
only risky, but also will tend to slow down and stagnate your
trading. Avoid them when possible.
Good luck in the markets!
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links included. Questions and comments can be sent to Ray at
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