CHAPTER 6

Common Mistakes and Pitfalls

There are some cautionary points to consider before you proceed to actually buying shares. The following are some common mistakes many novice traders make when entering the world of stock markets.

Trading Mistakes

Mistake 1: Not Doing Anything

Once you have developed a strategy to enter the market, what are you waiting for?

There is never a guarantee that the market will go up on your first day of trading, but if your strategy is fair and reasonable, then you would have entry and exit levels planned. The market may not be at your planned level to enter, but not placing a bid means that you have no confidence in your trading abilities.

As such, it is a truism that doing nothing at all will ultimately not provide you with a comfortable retirement.

A client came to me in the late 2015 and asked me what he should do with his investment in JSE-listed IT Giant Dimension Data. He had bought the shares in June 2000 when they were trading at 350 cents. The share then proceeded to climb to over R70 a share, but he kept them—refusing to sell. By 2003 the share had fallen to below 300 cents. In 2004, they underwent another recovery—this time to just under 650 cents—and still didn’t sell.

Not taking active participation meant a major loss.

Mistake 2: Starting Late

Postponing your trading aspirations is only detrimental to you. You already know that the earlier you start the better off you are.

Mistake 3: Investing and Debt

A common mistake is to believe that you have to pay off all your debt before you start trading. This is not the case. If is like stating that you have to pay off your car before you go on holiday.

If you are prepared to be a trader, then this becomes your career. You will have credit cards and vehicles and home loans. Take these factors into account when you are planning your trading strategy.

Mistake 4: Short-Term Investing

There is only one absolute in becoming a trader: you need at least 6 months’ worth of salary in a money market account. Professionals will tell you to only use funds to invest in the stock market that you won’t need for at least 3 years.

Really?

Plan and strategize. Then go for it…

Mistake 5: Playing Safe

If you’re young, most of your investing should be in the stock market. You have enough time to weather any market fluctuations and to reap the rewards of long-term gains. This doesn’t mean that you cannot trade the shorter term markets, like futures.

Always remember that the better you strategy may be, the less risky your trading will ultimately be, as you gain experience and skill.

Mistake 6: High Risk Shares

Not every trade is an opportunity and not every investment is for you.

You must determine your risk profile before you start your trading escapades. A financial mentor can help you to determine your psychological and risk-investing profile.

Mistake 7: Trading In and Out of the Market

The serious trader always has a well-prepared, yet flexible, long-term plan. Flexible, in that he or she should also be prepared to take short-term profits. Essentially, you should form regular trading as part of your long-term plan.

I am not suggesting that you should trade daily, as every trade comes with brokerage fees and country-related taxes. These often reduce short-term profits to break even.

Pitfalls

Pitfall 1: Not Understanding

If a trader buys securities he or she do not have a fundamental understanding of the triggers that could move this company’s share price, then simply put, he or she is placing each trade at risk. Trading without knowledge is pure guesswork.

Pitfall 2: Do You Have Risk Tolerance?

If a trader is targeting higher returns, but such strategy is causing sleepless nights, he or she should shift strategy to a more conservative, lower risk mixture of stocks.

Pitfall 3: Ignoring Trading Costs

Take account of all costs of buying and selling a stock. For instance, if a share costs 100 cents and costs of acquiring that share equates to 5 cents, then your acquisition costs are 105 cents. This means that the share has to rise by 5 percent before you break even.

Now, add the cost of selling the share and include taxes. Note that if you buy shares irregularly, you will be charged capital gains tax, but if you trade regularly (say, twice a week), you may be declared as a full-time trader and taxed at the full rate.

Assume that you get charged with only capital gains. You have to add this to your purchase price. This could push up the full share price to 112 cents a share. This means that you have to see the share rise by 12 percent before you break even.

Now, in terms of break even, you need to add inflation rate to achieve a real return on your investment. If the inflation rate is 5 percent, then your share must rise by an additional 5 percent.

One way to offset some of those costs is to trade through a limited company. In this way you can deduct costs associated to you company, such as office, telephonic bills, computer equipment, and Internet costs. For a more comprehensive strategy, send me a request for information to [email protected].

Pitfall 4: What Is Your Exit Plan?

A plan should always have an exit strategy. A strategy could be to sell the share when it reaches a 25-percent positive growth or a 15-percent decline. The issue is simple: Always have these plans set out before out make your investment. Before you buy the share, you have no emotional attachment to it, which means you can make totally rational decisions. Once you own the stock, you tend to get either greedy or scared. These emotions lead to a desire to preserve profits, leading to prematurely cutting off an ascending price trend.

Continuous losses impact a trader’s mental state, which then seems to perpetuate additional losses, breaking your trading confidence. An exit plan is thus one thing that an experienced trader always has before initiating a position. The reason is simple: You must have a plan and stick to it, or else every decision you make will be emotional, not rational.

Worse yet, some traders chase losing positions with even larger trades without proper analysis, hoping that they will quickly recover losses. Guess what? Losses escalade into critical financial fiasco. Some traders are effectively run out of their trading career.

An exit strategy must be clear cut, be completed and implemented before the trade is made. Such a strategy should cover all possible variables, outcomes, and expected returns, whether profitable or not.

Pitfall 5: Portfolio Imbalances

A Portfolio must always be balanced. This means that you should have a relatively equal amount of funds in each share that you have in a portfolio. This will prevent any single stock (or small group) to influence the entire portfolio.

Imagine that you have a portfolio of 10 shares, each worth about $10,000. This portfolio of $100,000 suddenly climbs to $140,000, all due to a single stock rising by 40 percent. Now, logic states that you don’t sell a stock that is climbing, but you also don’t want to be held at ransom by a single share.

I know that you could have a trailing stop loss to prevent significant losses if that share suddenly falls. The point is that there are times when a stop loss is bypassed. The share may have risen rapidly on the news or rumor that it is about to be acquired by a larger company. If those negotiations fail and cause the company to be declared bankrupt, the share price will fall past your stop loss. Following that, trade in this company will be suspended and ultimately terminated.

You had the option to sell the share at the higher price, but you didn’t? What should you have done?

There are strategies that can be implemented, which is a combination of the aforementioned. You could, for instance, sell enough of that company’s (Comp A) shares to recoup your original cost and buy another share (Comp B) that meets your portfolio strategy.

Now, do the following:

Remember that taking too large of a position (caused a portfolio imbalance) often leads to emotional attachments that could lead to poor and ineffective trading decisions. It also exposes the trader to possible significant portfolio damage, sometimes irrevocable.

Pitfall 6: Failure to Cut Losses

Some shares fall and do not bounce back.

Many novice traders believe that a share must bounce if it falls. This is a trading pitfall that sees novice traders begin to move from analysis to hope that the share falls. Every share has a level that is considered to be its fair value. If the share falls below that fair value, then it is an opportunity to see the share potentially bounce.

Such shares must be sold if they hit your stop loss.

There are times when shares that fall past fair value continue to fall. While this is a fact that should form part of a trader’s strategy, their actions are often opposite any logical course of action. Many hold on to these losers, hoping against hope that the stock will consolidate and return to its upswing.

Opportunity cost is another reason to sell a share that is falling. So, beware of the emotional compulsion to hold onto falling shares.

Pitfall 7: Selling Too Soon

Although selling a share too early might seem to be a relatively minor problem, it can actually become a serious one. In a properly diversified portfolio the potential profit from any one stock is far more than the potential loss.

That’s simply another way of saying that the most you can lose on a single stock is 100 percent of what is invested, but the potential gain from every stock is unlimited. If your objective is to make as much money as you can, then you must put yourself into a position to hold onto really big winners when they come your way.

If you have a strategy that emphasizes taking the money and running every time you get a double or triple, then you are seriously limiting your portfolio.

I believe the reason most investors fail to hold onto winners long enough is that they simply do not realize how big a move can sometimes be realized. They wrongly assume that if a stock has doubled or tripled then that is about the best they can hope for.

Sometimes a stock that has doubled will go on to make another tenfold increase. It can take years for this type of move to occur, but over a several years chances of finding a huge upward trend is far better than first imagined.

Another insidious reason for investors selling too soon is the use of price objectives. This is when you buy a stock and set a price that you will sell at if and when the stock makes it to the target price. These target prices are usually arrived at as a certain percentage above the entry price, or else are based on some analyst’s assessment of the “value” of the stock.

The use of target selling prices is a seriously flawed practice. One of the enigmas of the stock market is the tendency for what seems overvalued to keep going higher still, and what seems reasonably valued or cheap to keep on retreating. The reason is that when a company’s earnings are growing rapidly, the price of the stock may be high relative to the current earnings, but only a few times the following year’s actual earnings.

The stock may even be selling for many times the earnings estimate for next year, because it takes time for good trends to be recognized and assimilated by stock analysts. Thus, stock analysts’ earnings estimates for coming years tend to lag when something good is brewing, just as they often lag when bad things are in the works. The thing to remember about this is that the aggregate consensus of all market participants tends to be more accurate than published earnings estimates.

The use of price-selling targets mostly results in you capping your profits, as you cannot possibly make more of a profit than that which is reflected in the target price. It should also be obvious that a strategy that caps both loses and winners will ultimately limit the portfolio’s growth potential.

Don’t try to guess how far a stock can move up. If you do not give your stocks a lot of room to move upward, you will guarantee that your stock market profits will be below average.

Pitfall 8: Shares Are Falling, but You Keep Buying

Some traders believe that shares that fall must retreat if technical triggers turn, that is, highlight that the share is oversold. In order to profit from such a strategy, you need to be simultaneously right about two things:

The novice trader often assumes that if a stock is near its 12-month low then it must therefore be in an opportune position to be bought. In addition, these traders convince themselves that buying such a share is not risky, because of that stock’s low price relative to past earnings and book value. In reality, buying such a stock is always risky.

Traders must be aware that analysts’ forecasts are based on sound knowledge, which includes discussions with management. So, if a stock is in a serious decline, it could be because market experts know some facts about the company’s future earnings potential that the novice doesn’t. Try looking at director dealings and, if these directors are selling their own shares, then you will understand why the share is in a downward spiral.

Keep in mind that a trader’s objective is to maximize continuous profits, not to try and outsmart the market.

Pitfall 9: Averaging Down

Adding to a losing position is simply too dangerous for the novice trader.

The reasoning in the mind of the investor is that the average cost per share will come way down once he or she adds to the position. This is called cost averaging, which is buying a certain amount into a stock at specified time intervals or at specified price intervals.

Over the past decade, I have used both systems and conclude that Time-Based Cost Averaging can work if done in a controlled manner. Price-Based Cost Averaging makes no sense in any circumstances and is sure to bankrupt you if practiced consistently. Usually, the trader sells his winning shares to buy more of the losing ones. If he or she continues to do this they will end up with a low priced losing stock, but one that is higher than the market price as he or she has been averaging down.

Pitfall 10: Emotional Attachments

Some investors have a difficult time selling shares, because they have become emotionally attached, such as shareholders who have inherited shares and feel “guilty” in selling these. What your emotions tell you to do and what you should do are two different things.

It might be an obvious statement to state that a share can grow significantly over the years, but what many traders ignore is that a company will reach a stage of maturity and growth will slow, which in turn means that EPS will slow and consequently the share price will slow.

Therefore, traders must learn to take profits as success builds confidence, skill, and experience. However, you need to ensure that you find a balance between selling too soon and selling too late. This must be based on analysis and your actual stock performance and not, as some suggest, calculated guesswork.

Try to remain emotionally unattached to a stock so that you are not blinded to what the market is telling you about it.

Pitfall 11: All Your Eggs in One Basket

The proverbial basket is made up in different ways. First, if you invest in only one share, then that investment is 100 percent at risk, in controllable and uncontrollable market forces. So, select a decent sample of shares. Remember that the more shares you have in a portfolio means additional and extensive analysis.

Second, when the basket consists of shares in only one sector, such as all mining companies, then-when the sector cycle changes, all your shares will be on the downswing.

Third, the basket is risk related, if you are risk averse, you should have more blue chip shares than middle caps or high risk. Too many in one sector exposes you to either low returns (blue chips) or higher risk (low-priced shares).

Last, the basket is focused on only one type of security, such as all equities or bonds. In this manner, the trader assumes additional risk of losing money in any given year as various securities are driven by different forces. It thus makes sense to keep some assets in each class to counterbalance the cyclical nature of markets.

Pitfall 12: Everyone Is an Expert

Trading on advice without fundamental and technical analysis is pure guesswork. Remember that this is your career and not a hobby, so be professional.

Pitfall 13: Get Rich Quick

Trying to beat the market is as old as time itself. Yet, it is important that this is not a poker match. You do not have to beat someone to make a profit. Keep your trades professional and to yourself.

Talking about your “wins” will not make you friends.

Pitfall 14: Panic

Many traders panic at the first sign of a decline in the value of a specific share, while the professional sees a decline as an opportunity. Once the preceding basic rules have become part of the traders’ mindset, strategies have to be formed to select, buy, maintain, and sell shares.

Chapter 7 assesses the common traits, which most successful traders seem to have.