If you can identify these top 9 mistakes that traders make, then you can improve your results.
The stock market consists of people who are all driven by emotions. Because of this, a lot of trading decisions are impacted by these human emotions. In this article we list common mistakes that traders make.
1.Refusing to sell at a loss
There is a term called “loss aversion”. This means people would be rather avoid losing money than gain money. Studies have shown that in the stock market, investors have more of an emotional response when they lose money as opposed to when they make money. Losses are much more psychologically powerful than gains. This is because the investor feels more pain when losing out on money they already had than making money they never had.
This loss aversion can cause traders avoid cutting losses for too long. This in effect can cause more pain down the track if the loss continues to grow.
2.Not having a plan
Traders should consider having a plan when entering into a trade and a stop loss for the trade. To avoid not cutting losses quickly enough, a stop loss will allow a clinical approach to the stock. So if it hits that level, then it will sell it.
3.Incorrect Position Sizing
A trader can be overexposed in a position if they risk too much capital on one stock. The problem with this strategy is if the stock falls, the capital at risk also falls. The optimal position size reduces risk for the investor. Traders should work out how much they are willing to lose and then calculate their position size from this. Stop losses should also be in place so the trade is exited to preserve capital.
4.Volume
Traders should wait patiently until a confirmation of the direction of the stock has been verified with large volume. Without volume, it is a weak signal.
5.Overdiversification
A portfolio can be overdiversified and this does not reduce the risk of the portfolio any further. The optimal number of stocks in a portfolio is only 20. With an over-diversified portfolio, there can be too many stocks to keep an eye on.
6.Buying when the stock is going down
Many long-term investors believe this to be a good strategy. They tell themselves that they are in for the long term in order to feel better about their losses. But when a stock is falling it could continue to go down. Not all stocks fall because of silly reasons. Often there could be something fundamentally wrong or fatal about a company. For short term or medium-term traders, this strategy is also not effective as capital can be better utilised elsewhere on stocks which have upwards momentum. Investors could be waiting for years for a stock to recover – an even that is not guaranteed.
7.Letting your ego get in the way
Not wanting to admit you are a wrong and holding on to a stock is detrimental to the performance of your portfolio. Traders need to let go of losing trades and find other opportunities elsewhere. Wanting to be right will cost the trader the opportunity cost of having their capital invested better. Often the market is right, not you. Listen to the market.
8.Following the crowd
During the dot.com bubble, there was excessive speculation on many high-tech companies. Many of these companies went into liquidation as they were not making money and operating on large levels of debt. There was a real fear of missing out in the stock market during this period. Many traders, wanting to a part of the stock price growth then went and bought into positions. However, as we can see from this situation, blindly following the crowd is not a good idea and traders should do their own research and not follow hyped up stocks.
9.Buying too many stocks within the same sector
There are issues with being too diversified but there are also issues being too concentrated in a particular sector. When stock prices are moving up, then the portfolio looks good. However when that sector is weak, then the portfolio suffers.
Lauren Hua is a private client adviser at Fairmont Equities.
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