UV Market Blogs

Tuesday, November 21, 2006

Risk allowances

Risk, while unwanted, is the reason why your portfolio has the ability to grow in value.  The amount you earn on your investment is correlated to the amount of risk you are willing to take.

CDs and money market accounts are considered to be zero risk because they are insured by the FDIC in the US.  Investments into hedge funds are usually higher risk because the capital is invested into various stocks and ETFs that are not guaranteed by any governing body.

You should never be willing to lose more than 2% of your account balance on any one transaction.  This is a simple rule that the new investor and the hedge fund manager alike should follow.

To make money, you need to first figure your win to loss ratio.  The number is not very important.  Unlike competitive sports, you can still be a winner if your win to loss ratio is 1 win to every 99 losses.  Your win loss ratio won’t decide whether or not your portfolio makes it to a bowl game.

After you have found your win loss ratio you need to find the appropriate stop loss and take profit to set on each trade.  Assuming your win loss ratio is 50:50, you should set your take profit slightly higher than your stop loss.  This means that you should set your stop loss to an 8% loss on the trade but your take profit at 10%.  After 100 trades you will have made 10% on 50 trades and lost 8% on the other 50 trades.  While you were not perfect, you will have made money.

Some investors make money with ratios as low as 1:20.  Investors who invest in the most speculative of investments are usually willing to lose 20 times for just one win.  The one win will have been a huge gain; enough to cover the previous losses and then some.

A trader who only wins 1% of trades can beat a trader with 99% accuracy simply because of the amount of assumed risk and the amount gambled on each trade. 

Don’t be upset if you can only win a few trades out of every 10.  This is perfectly fine, all you need to do is adjust your stop loss and take profit levels so that you can profit from a losing record.  The key is to cut your losses and let the winners run, but since we aren’t psychics this turns into a wild guess.

Study your recent trend history and develop a strategy for making the most out of your trades.  Average your take profit to find what will work best for your strategy and make your stop loss conform to your win loss percentage.

Anyone can win 1% of trades but it takes an informed investor to turn that 1% into profits.

No brokers

No brokers

The markets are cut throat.  What may seem like a helping hand can also be a one way ticket to a non-existent portfolio.  I have very little experience with stockbrokers and that is just enough for me.

As a stockbroker, your job description is literally “pawn off the stocks the firm wants to dump.” First and foremost the stockbroker is employed by the brokerage firm and will seek to protect the interests of his or her employer rather than that of the everyday investor with holdings at the branch.  The job of a stockbroker is to sell what the brokerage house wants to sell rather than the best investment for the client.

Stockbrokers might as well be used car salesmen.  Look at it this way, if there are shares that you can purchase, there are other people who no longer wish to be involved in the business.  A sale happens because one party, for one reason or another, is no longer interested in possessing a product and another individual desires the product.

Stockbrokers are necessary for the majority of investors to place trades on the market.  Unless you are the owner of a seat on the exchange, you will need to use a stockbroker to buy or sell a security.  Some funds are only available through the use of a stockbroker (who receives a commission on the sale).  The job of a stockbroker, essentially the middleman, will always exist because most people do not have direct access to the markets. 

Technology is slowly taking over the investing scene.  Through various online brokerage firms, and investor can place trades for just a few dollars up to ten thousand shares.  These low fees make it available for an investor with any size portfolio to make an investment.  Stockbrokers need not be an individual to be considered a stockbroker.  Etrade and Charles Schwab are both considered stockbrokers however they are corporations rather than individuals who partake in the business of brokering stocks.

It may be necessary for you to call in your trades to your broker.  While it is necessary for you to use the broker to invest, you do not have to heed every investment decision he makes for you.  The casual investor will usually accept the word of a broker to be accurate and in the best interest of himself.  The brokers do have extensive knowledge of the markets, right?

WRONG!  To obtain a license to become a stockbroker you need to know the laws.  Especially in the United States, the examination for a license requires that stockbrokers know all the ins and outs of laws reguarding the financial markets but do not test for financial literacy.  To be quite frank, a broker does not need to know anything about how to pick good investments.

I don’t know about you, but I sure do no want my investment dollars in the hands of someone who has not yet proven to be profitable in the markets.  This is why for the casual investor I would choose mutual funds for investments.

The managers of hedge funds and mutual funds are paid by incentive.  A manager who outperforms will make more money than a manager who loses.  There is a reason for a manager to perform well as it will help him personally.

A stockbroker is paid by the amount of stock he or she is able to solicit to his or her clients.  The fees are usually flat fees but can also be a percentage of the overall investment.  If the trading house needs to sell unwanted shares of a company, the firm can offer extra payments to brokers who move the stock.

In simple terms:
Brokers make money by selling securities to investors
Managers make money by returning the best possible returns to the investors.

Don’t listen to your broker and make your own analysis of every investment before you decide to invest.  Read the fine print and do not take your broker’s word as perfection.  You will save lots of money and probably learn a thing or two along the way.

Trade like a rock

Trade like a rock

The dictionary defines rocks as: “mineral matter of variable composition, consolidated or unconsolidated, assembled in masses or considerable quantities in nature, as by the action of heat or water.” But in this case I mean it to be a boring hunk of stone that neither thinks nor feels pain or emotion.

Becoming a professional investor, or at least a serious investor, requires an emotional disconnect between both your money and your status.  When involved in such a volatile market you should not have any emotional attachment to an investment.

You should not invest in any company simply because you work for it.  This is one of the biggest downfalls in the portfolios of many investors.  Your future is in jeopardy when you work for a company and also have investments in the company.  If the company goes under, you lose both your job and your investment.

When I trade short term and often high risk timeframes I like to set my trades and forget them.  I always make sure to set my stop loss and take profit then leave from my trades.  If a trader sits and watches his trades move up and down each point or pip at a time, they will be more likely to lose.

Emotions run thick in trading.  Unfortunately, whether we are willing to admit it, we are tied to our money.  Money has become a necessary evil in life.  To earn in investing, one must first people able to accept a certain level of risk in order to succeed.  Each time I make a trade, it literally marks whether or not I will be eating that week.  Every gamble is an important part of my livelihood.

When we bring ourselves to worry about what may happen if the money is lost we start to assume unnecessary amounts of care.  When I first started trading I had a habit that left me in the red, and only until I started to leave my trades alone did I recover.  I would watch my charts as my positions gained and lost through normal daily trading.  A small swing would send my heart pounding.

Many times I found myself closing out of trades because I was so emotionally stirred.  I would sell way before my stop losses were reached and sometimes take profits of just a few dollars. 

I later learned that in order to be successful I was going to have to care less about my trades.  To participate in the markets I had already assumed risk with my capital and it was time to convert that risk to profit.

I don’t know when it happened or why but I started to set and forget.  Set and forget became my new slogan.  I would set my trades in the morning (before I left to go to high school) and come home to see my profit or loss.  Often my positions were still open when I got home and I had to immediately leave my trading platform or I would be too overbearing on my account.

The key is to not micro manage your money.  It is one thing to be a thorough investor, but you should not be sitting over your investments with a magnifying glass.  Your portfolio is like an ant farm.  Keep feeding it periodically and let it mature on its own.  I could never disagree that watching your portfolio rise from pennies to thousands to your retirement is a delight, but we must make certain to know that watching can also be self destructive.

Trade like a rock.