Wednesday, November 15, 2006

What Kind of Investor Are You?

Were you taught to be a "buy and hold" trader? Exactly what does that mean? In the classes I give, I always ask: "Buy and hold until when? Death?" That can work very well for your heirs, but how about for you? There is no question that buying and holding for the long term can be an excellent strategy. Just take a look at the Dow 30 Industrials over the last thirty years or so. The charts show a nice uptrend over that period and if you bought the Dow thirty years ago, you'd be holding a nice gain. Suppose, however, that you bought in May 2001 and that you had an emergency and needed the money in October, 2002. Or suppose you decided to start investing for retirement fairly late (as many do if they do it at all). Let's say in the middle of 1999, you saw the market had been rocketing so you bought some mutual funds for your retirement day in the middle of 2002. What happened? Between the middle of 1999 and the lows in October 2002, the Dow Industrials dropped about 3000 points, the Nasdaq fell around 3700 points from early 2000 until October 2002 (and hasn't yet reached the 2000 levels), and the SP-500 dropped more than 600 points in that same time frame. Even now, years later, you probably would not have recovered if you began as a buy and hold investor in 1999 or early 2000. Of course, if you had years to go, maybe you would wind up successfully. History would suggest an ultimate gain.

When you look at the kind of investor you are or are going to be, you should consider who you are. Are you someone who can afford to buy and hold for 30 years or so? Are you in a position to invest in that fashion? Or are you someone who needs most of their earned money each month to pay the mortgage, car payments, taxes, insurance, groceries, credit cards, etc. and after all that have little if anything to lock away for the long term. That is certainly the more common picture. If you fall into the latter category, what sorts of things can you do to invest in stocks and options? First, you must recognize that your early trades will have to be small. In my earlier article on money management, I suggested that it is wise to make trades using equal percentages of your *risk* money. 3% to 5% of risk money is often a percentage that is suggested per trade, buy if you only have a couple of thousand of risk money, that means your trades would be limited to $60 or $100. That may not be enough when you factor in commissions. You could opt for equal dollar amount trades in the beginning. Perhaps you could initially make $400 trades if you were starting with only $2000 in risk money, but that is still 20% of your money. My suggestion would be to paper trade while you saved enough to increase your risk money. Paper trading means making trades with pretend money; practice trading and keep records of what you are doing. Learn more about trading as you increase your risk capital. In other words, increase both your knowledge and your cash before you trade with real cash. You can learn by watching what professional traders do in subscription services, by reading, by attending classes, by watching trading DVD's, by talking to successful traders. As you do those things, you also practice trading until you are confident in your own abilities to trade in a disciplined fashion, to cut losses, to manage your trading money, and to follow your personal business plan. Only then should you consider risking your own hard earned money.

Once you believe you have the knowledge to trade and to appreciate and manage risk, you can consider what kind of trader you will be. Of course, you may choose to simply select fundamentally sound companies and buy the stock for the long term. That strategy can be great, but you must recognize that it can be awfully painful to sit through long and sometimes very sharp down turns. You need to understand that when a position drops 50% it needs to then increase 100% just to return to even. Instead, you may decide to choose to employ a more "trader-like" approach. If you are bullish, for example, you only stay in positions until they break down through a trend or break support and you don't stay in throughout complete retracements. You get out when the stock stops being bullish and you know you can get back in after it has ended its' bearish leg. You can also play a stock in both directions. Instead of just trying to make money when a stock goes up, and then either ride it down or get out for the down move, you can learn strategies with both stocks and options to make money both when the stock goes up and when the stock goes down.

Trading and investing in the stock and options markets can be extremely rewarding, but it also involves very serious risk. That is why I often wonder why so many people literally spend no time learning how to invest or how to trade. Taking the time to increase your knowledge can increase your profits, reduce your losses and, ultimately, if you are successful, lead to meaningful positive changes in the quality of your life. Successful investing can give you a better retirement, help pay for college, enable you to have more free time, let you contribute more to charities, and have numerous other wonderful consequences. Take the time, make the effort to increase your investing knowledge. You'll probably enjoy learning and the rewards could change your life. It's always your money that you are risking so don't risk it without knowing what you're doing.

Bill Kraft, Editor
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