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7 Deadly Trading Sins, and How to Atone

Trading tips to help you beat greed, pride, and five other common investing pitfalls

by 10/29/2012 12:20:43 PM
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Despite our best intentions, the inherent fallibility of our human nature means that we occasionally commit grievous transgressions in our trading. Unfortunately, all of the research and investing capital in the world won't guarantee investing profits if you're succumbing to emotional self-sabotage as you trade. Trust us -- even if you're not a fire-and-brimstone type in your personal life, it's probably safe to say that you've got a few investing sins on your conscience. To find out how to overcome the weakness of the flesh and transcend your baser trading instincts, keep reading.

Greed

Greed -- or avarice, if you're a die-hard medievalist -- is probably the easiest of the trading sins to commit. After all, the purpose of investing is to make money, right? But there's a difference between targeting reasonable profits and swinging for the fences at the expense of common sense.

To be clear, the desire to make money is not a vice in and of itself (at least, not in a capitalist society, it's not). In fact, traders are most likely to commit the sin of greed after they've already entered a position... and the profits are beginning to add up. Once the greedy trader sees his returns top 25%, all he can think about is doubling that to a 50% gain. But once the position is up 50%, why not hike the target to 100%? And so it goes on like that into perpetuity -- or until the stock becomes ferociously overbought and reverses hard, erasing those tantalizing paper profits the trader could have once collected.

Penance: You can atone for your profit-chasing ways by setting a target exit point for each trade. A target exit point is the logically based underlying stock price that would result in a substantial, yet attainable, profit. Set your profit objectives in advance, and determine the appropriate target exit point before you trade. Just as crucially, resist the temptation to raise your profit objective as the price of the stock nears your target exit point.

Gluttony

All traders are probably guilty of having a "pet" stock or sector that's their perennial favorite. This might be due to the investor's relative familiarity with the industry, a track record of wins on one particular stock or sector, or -- in some cases -- a basic gut feeling.

While there's nothing wrong with playing your favorite stocks as part of a balanced and diverse investing strategy, a trading glutton makes the mistake of overweighting his portfolio toward one small slice of the broad-market pie. The market environment is always subject to change, and the tech-heavy approach that worked so well last quarter might play havoc with your returns this quarter.

In other words, investors who commit this sin are violating the old axiom, "Don't put all of your eggs in one basket." It may seem trite, but diversity is crucial to trading success.

Penance: Diversification should happen in two dimensions. Rather than loading up on one favored stock or sector, (1) spread your investing capital across a variety of sectors; and (2) carefully seek out a mix of both bullish and bearish trading opportunities. By following this advice, investors will be poised to profit regardless of overall market conditions, and trading capital won't be completely decimated by one wrong guess. Options are an ideal way to add diversity to a portfolio. A combination of puts and calls offers exposure to market swings both bearish and bullish, and options on exchange-traded funds (ETFs), in particular, are a user-friendly way to spread your investing dollars around.

Sloth

There are actually several different ways laziness can undermine your investing success. In particular, though, we're talking about the kind of slothful investor who's trotting out the same analytical tools and strategies he used back in the 1980s. In a rapidly changing market environment dominated by hedge funds, high-frequency trading systems, dark pools, and algorithms, traders have a responsibility to keep up with the times and adjust their approach accordingly -- or risk rapidly diminishing returns.

Essentially, traders have to "adapt or die," according to Schaeffer's Senior Technical Strategist Ryan Detrick. "I've been trading for over a decade and things have changed so much," explains Detrick. "If you had an 'edge' a few years ago, there's an above-average chance it doesn't work anymore."

And if you're guilty of this offense, don't let inflexibility compound the problem. "As traders, we always need to be on the lookout for ways to improve," explains Detrick. "And the No. 1 way to do this is to be aware of tactics that just aren't working for you anymore. Don't keep trying to make them work."

Penance: To counteract the gravitational pull of sloth, you must make a concerted effort to broaden your horizons. If you always consult The Wall Street Journal for your investing news, mix things up by reading Bloomberg Businessweek for a change. And as traders increasingly flock to social media sites like Twitter, tap into the hive mind to find new trade ideas, indicators, and points of view. As long as the market keeps changing, remember -- you're never done learning.

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