How to Avoid These 7 Deadly Trading Sins

If you've committed any of these 7 trading sins, keep reading to learn your proper penance

by Elizabeth Harrow

    Published on Nov 27, 2015 at 11:07 AM

    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.

    Trading Sin #1: 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.

    Trading Sin #2: 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 clichéd, 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.

    Trading Sin #3: 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. So if you're guilty of slothful trading, don't let inflexibility compound the problem.  In today's fast-paced market, if you had an "edge" a few years ago, there's an above-average chance it doesn't work anymore. Be aware of tactics that just aren't paying off for you anymore, and 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.

    Trading Sin #4: Lust

    Anthropologists have not yet been able to pinpoint a specific date, but at some point in recent history, it became acceptable for analysts and pundits to describe stocks and sectors as "sexy" or "not sexy." The shorthand typically refers to the differences between, say, a high-growth tech stock and a dowdy old Dow component peddling toothpaste (with apologies to Procter & Gamble). As a general rule, traders are overwhelmingly attracted to the potential for big, breakneck rallies and outsized growth, whereas long-term stability and steady dividends ostensibly inspire Street-wide snoozing.

    But when you're putting your hard-earned dollars on the line, the last thing you should do is chase after that shiny new distraction of an Internet IPO that's drumming up Beatles-level hysteria (with apologies to Facebook). As the great contrarian Humphrey B. Neill said, "The crowd is right during the trends but wrong at both ends." Nobody wants to be the last guy on the bandwagon -- but that's exactly where you'll wind up if you blindly invest in the latest, hottest, "sexiest" stock the talking heads on TV are all touting.

    Penance: For starters, you may want to read Neill's classic book, The Art of Contrary Thinking. Then, begin to apply the principles of thoughtful contrarianism to your investing (which means you're cautiously skeptical of the consensus opinion -- not knee-jerk contrary). For example, if you notice media coverage toward a specific stock or sector swinging dramatically toward one end of the sentiment spectrum, ask yourself: Is this bullish (or bearish) attitude justified by the stock's technical and fundamental performance? If the answer is "no," you've taken the first step toward identifying a potential contrarian trading opportunity.

    Trading Sin #5: Wrath

    It's perfectly natural to get angry or upset when a trade moves against you or doesn't play out as expected. However, wrath becomes a fatal flaw if you allow it to influence your next move. When a strategy goes awry, one of the worst money-management mistakes you can make is to double down on your next trade in order to "avenge" that loss with a big winner.

    To be blunt, that's because losing streaks are not only possible, they are inevitable. A perfectly successful trader might have a "batting average" of .350, which means he's striking out on a full 65% of his positions. Given those odds, and a sufficiently lengthy timeline, it's simply unavoidable that investors will encounter strings of two or more losing trades in a row with some regularity.

    So, if you're placing extra capital into successive trades in the hopes of "getting back" at the market for your losers, you're simply setting yourself up for a costlier kind of failure. If you insist on upping the stakes with every new opportunity, a very average losing streak could eventually decimate your trading account. And when that happens, you won't even be able to stay in the game -- let alone make up for lost profits.

    Penance: Traders with a short (or nonexistent) fuse should be scrupulous in their money management, particularly as it applies to allocation. When you already have a system in place to control how much money you're committing to each trade, it's easier to stay disciplined (and suppress the urge for vigilante trading justice). The concept of fixed fractional position sizing dictates that each trade receives a predetermined percentage of your trading capital -- for example, 10%. This allows you to increase the size of your bets as you collect winners, while putting proportionally fewer dollars at risk when the momentum is moving against you. Conversely, in a system where you commit the same fixed dollar amount to each position, you lose the ability to maximize winning streaks and control losing streaks.

    Trading Sin #6: Envy

    Let's subtitle this sin "Keeping Up with the Buffetts." There's a persistent obsession in tracking the moves of celebrity investors and hedge-fund managers, with articles and websites promising to give all of us Average Joes the inside tips we need to start trading like Warren Buffett ... with the implication being that you, too, can magically transform into a benevolent billionaire with a homegrown fortune built on Dairy Queen Blizzards and Coca-Cola Classic.

    Here's the rub, though: If it were that easy to be Warren Buffett, we'd all be Warren Buffett already. The man's trading decisions have been a matter of public record, via SEC filings, for decades. If it were a simple matter of aping his buy and sell orders after the fact, the U.S. would be overrun by wealthy investors begging for tax hikes.

    And as the Oracle of Omaha himself would tell you, it's taken a combination of careful analysis and years' worth of patience to build up his fortune -- and even at that, Buffett's as vulnerable as the rest of us to plain old luck, for better or worse.

    So, aspiring to learn from his experiences? That's fine. Thinking you can replicate his success with a $10,000 trading account and the same set of public records available to everyone else on Wall Street? That's a setup for disappointment.

    Penance: Slavish devotion to the Gospel of Warren is its own unique brand of idol worship, and plenty of otherwise-pious traders are guilty of this offense. The key to curing your crippling case of envy is to clarify your own investing goals. Are you a conservative investor with an eye toward dividend payments, or an aggressive day trader looking to cash in on triple-digit gainers? Are you trying to supplement your current income, pad your kid's college account, or hit the jackpot with a few big winners and retire early? If it helps, write out the answers to these questions as an investing mission statement. Your ultimate goal(s) -- and no one else's -- should determine what kinds of trades you make, when you make them, and how you manage them.

    Trading Sin #7: Pride

    Pride comes before a fall, and ego leads to many a costly trading decision. Obviously, playing the market requires a certain level of confidence in one's analytical skills, but there's often a very fine line between confidence and arrogance. The former trait is what allows you to ride out the short-term bumps in the road with an eye toward long-term success. The latter quality causes traders to cling to their losers in the stubborn belief that it's everyone else who's wrong.

    The blunt truth is that you shouldn't be misled by the notion that you're "smarter than the market," because -- as the old adage goes -- the market can stay irrational longer than you can stay solvent. Price action is all that matters, so don't hesitate to question your assumptions, and consider the possibility that you could be playing the wrong side of a trade.

    Penance: When a trade (or the entire market) is moving against you, don't bury your head and dig in your heels. Instead, take a step back and reconsider the rationale behind the trade. And do so with a cold, calculating eye to avoid the pitfall of confirmation bias, where you're simply digging up data points to support your preexisting opinion. It's entirely possible you've missed a crucial fundamental catalyst that throws your entire analysis off the rails. Or perhaps there's been a shift in the direction of the broader market or sector, and your trade is getting taken along for the ride. In any case, it's important to determine whether you've hit a minor rough patch, or if it's time to cut that loser short altogether. Remember: your failures don't define you, but the way you deal with them does.


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