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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Some traders prefer to take a bottom-up approachMastering the Market In the previous chapter, we examined some of the macroeconomic events that can cause changes in the stock market. Rising interest rates, comments from the Federal Reserve, and economic reports can all cause changes in the economic outlook, which can cause stock prices to move sharply higher or lower. When one examines the economic outlook in order to make investment decisions, it is known as a top-down approach to investing. Some traders prefer to take a bottom-up approach. In this case, you are more concerned about the individual investment. For example, you might start by studying an individual company and understand its details before making a decision. In this chapter, we take more of a bottom-up approach. We want to help you identify the fundamentals of profitable investment. You will have to decide, probably by trial and error, which of the many analytical techniques and market-forecasting methods work well for you. I find many investment tactics to be irrelevant to profit making, preferring to use strategies that are nondirectional in nature. However, there are a few basic guidelines that will enhance your ability to increase your account size consistently by making good investment selections. DESIRABLE INVESTMENT CHARACTERISTICS Finding promising trades is perhaps the most difficult issue to address when first starting out in the investment arena. While there are no absolutes, there are a few guidelines that will enhance your ability to identify profit-making opportunities. A desirable investment has the following characteristics: Involves low risk. Has a favorable risk profile. Offers high potential return. Meets your time requirements. Meets your risk tolerance level. Can be understood by you, the trader. Meets your investment criteria. Meets your investment capital constraints. Involves Low Risk First and foremost, a good investment must have low risk. What does low risk really mean? The terms significance may vary with each person. You may be able to accept a risk level of $5,000 per trade based on the capital you have available. However, an elderly person on a fixed income may find $100 to be too much to risk. Acceptable risk is based on your available investment capital as well as your tolerance for uncertainty. You should trade only with money you can afford to lose, as there is risk of loss in all forms of trading. Has a Favorable Risk Profile Every time you contemplate placing a trade, you need to create a corresponding risk profile. Whether you trade shares or commodities, invest in real estate, or put your money in the bank, every investment has a certain potential risk/reward profile. Some are more favorable than others. Studying a risk profile can show you the potential increasing or decreasing profit and loss of a trade relative to the underlying assets price over a specific period of time. As the variables change, the risk curve changes accordingly. In order to find the best investment, you have to look for trades that offer optimal risk-to-reward ratios. For example, which of the following investment choices has the better risk-to-reward ratio? Trade A: potential risk of $1,000; potential reward of $1,000. Trade B: potential risk of $1,000; potential reward of $5,000. Anyone would rather make $5,000 than $1,000. However, to actually make a good decision, you must also have enough knowledge to discern which trade has the greater probability of working out. Another key ingredient is time framethe time it takes to make the money. If trade A can make me $1,000 in one month with a 75 percent chance of winning, and trade B takes a year to make $5,000 with a 75 percent chance of winning, I would rather go with trade A. In one year, I could potentially make $9,000 [(12 1,000) .75] repeating trade A, and only $3,750 ($5,000 .75) using trade B. This is referred to as an expected value calculation. The risk/reward profile of any investment must take into account the following elements: Potential risk. Potential reward. Probability of success. How long the investment takes to make a return. Offers High Potential Return Risk comes hand-in-hand with reward. A trader cannot be expected to take a risk unless reward is also in the equation. Believe it or not, I have seen countless investors make foolish investments where the risk outweighs the reward many times over. Why would they do such a thing? Usually because they simply havent taken the time to verify the potential risk and reward of the trade or they are taking advice from someone who doesnt know any better. The best investments have an opportunity for high reward with acceptable risk. In addition, the good trades have a high probability of winning on a consistent basis. I consider 75 percent an acceptable winning percentage. This means I win three out of four times I place a trade. A baseball player who could do this would have a .750 batting average which is unprecedented in baseball history. Meets Your Time Requirements The process of locating and monitoring your investments must meet your time constraints if you are to be successful. In other words, if you do not have the time to sit in front of a computer day in and day out, then your best investments will not be day trades (entering and exiting a position in the same day). If you dont even have the time or inclination to look at your investments over a one-week period, then you have to take this into consideration. The time you have available for making investment decisions and monitoring those investments will affect the types of investments you should make. If you dont have enough time to pay attention to a trade that needs to be closely monitored, chances are youll lose money on it. The best investments will match your time availability. Meets Your Risk Tolerance Level Your risk tolerance level is directly proportional to your available investment capital. Risking more than you can afford to lose creates stress that impairs your ability to make clear decisions. Some people have the ability to handle uncertainty better than others. It is important to accurately assess your own risk tolerance levels and stay within those boundaries as you progress up your own trading learning curve. As experience in the markets naturally develops your confidence level, your risk tolerance level will increase. Can Be Understood by You, the Trader One of my most basic investment rules is as follows: If you dont know how hot the fire is, dont stick your hand into it. This rule is broken on a consistent basis by many beginning and intermediate traders. In addition, many seasoned traders singe their fingers as well. Basically, if you dont understand the exact characteristics of a trade, it is better to walk away from it. It is imperative that you familiarize yourself with the trades you place. Each trade has a unique personality. Your personality and your trades personality have to match for you to be successful over the long run. Meets Your Investment Criteria Your personal investment criteria can come in many shapes and sizes. Each individual has personal goals, expectations, and objectives when making investments. When I ask my students what they want out of their investments, the typical response is to make money. However, there are a number of related issues that also must be evaluated, including: 1. Capital gains (stocksmedium- to high-risk securities). What are the tax implications of your investing and trading practices? 2. Interest income (fixed income securitiesmedium-risk bonds and lowest-risk U.S. government securities). Is your objective to earn interest income? 3. Security (government securitieslowest-risk securities). Do you want to invest in only low-interest, low-return investments such as U.S. government securities (e.g., Treasury bonds)? Meets Your Investment Capital Constraints Do the investment requirements match your capital available for investment? Just as your investment strategy must meet your personality and time constraints, the capital you have available will have a major impact on what you invest in, how often you invest, and the number of contracts you can afford to trade. For example, if you have a small account (less than $10,000), you will invest very differently from someone with $1 million. In addition, if youre trading commodities with a small account, you should trade in markets that have low margin requirements and good return potential. You should stay away from the high-margin markets such as the S&P 500 stock index futures. No matter how much money you have to invest, start small. I have taught a variety of people over the years with a very wide range of capital available for investment. I advise them all to start by trading small until they figure out what theyre doing. Whether you have $1,000 or $1 million, you have to learn to walk before you can run. In the beginning, I recommend risking only 5 percent of your account on any one trade. In this way, you can afford to learn from your mistakes as a novice trader. Often, having too much money as a beginner can be detrimental. The more money you have, the greater the chance of overinvesting and making costly mistakes. I find that the best long-term investors are very cautious early on. However, they systematically increase the size of their trades based on the steady increase in capital in their accounts. For example, you may begin with $5,000 and choose to invest 100 shares at a time, then not increase to 200 shares until such time as your account has doubled to $10,000. |
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