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This article appeared in the July 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Avoid these pitfalls and you’re on the way to trading success.

Photo of Gary Stone By Gary Stone, Share Wealth Systems

As new traders and investors continue to enter the world of financial markets, there are a number of traps that the majority of inexperienced market participants fall into. Many of these traps are common, and you need to know what they are and how to avoid them.

This article looks at 10 of the more important traps, for inexperienced and experienced investors alike, and how some simple steps will help you avoid them along your trading and investing journey. Learn more by registering for a free trading DVD.

1. Using discretion and ‘gut’ feel to attempt to time the market and make investment decisions

This is undoubtedly one of the greatest traps for inexperienced sharemarket investors, in particular those lacking, or not willing to learn, the skills needed to survive and prosper. Thousands of variables affect the markets on a daily basis, so it is impossible for anyone to instinctively know what will happen next, either in the overall market or to individual shares. To avoid this trap, learn analysis skills that enable you to make informed investment decisions and not run on instinct, adrenalin or tips.

2. Not having a written trading plan

In any business, a plan is essential for success. A share trading plan provides structure and purpose, and a valid set of rules and guidelines with which to engage the market with consistency and discipline. It is a roadmap to negotiate the markets maze and contributes much toward avoiding trap No.1 above.

Your trading plan will include personal details such as reasons for trading, financial goals and skills objectives. It will also detail how you achieve your goals through rules governing timing entry and exit, portfolio and individual trade risk management, and position sizing. A plan will help keep you focused and on track during the good and tough times you will experience when trading the sharemarket.

3. Having a trading plan but not following its rules

I have encountered many examples of this trap. People will set out with all the right intentions and compile a detailed trading plan that gives a clear and unambiguous set of rules for engaging the market. Then it all unravels when they start actively investing: a couple of trades do not work out how they expected, they listen to advice from an outside source, or place a couple of trades based on gut feeling or opinion.

They then place a few trades that are larger than their rules allow for, and a whole new set of emotions bubble to the surface, causing anguish and grief as they start floundering around looking for new and ‘better’ ways to trade. This cycle of negativity can be avoided by implementing and sticking to the rules of the trading plan you have taken the time to develop and trust. It is one thing being aware of what to do, it is another executing that awareness under pressure.

4. Not understanding or thinking in terms of probabilities

Trading and investing is really a numbers game in which we need to understand the probabilities of the method we are using to generate profits from the market. Our probabilities of success are determined by the ‘edge’ we have in the market. An edge is a system or methodology that produces a profitable outcome over a large sample of trades; obviously, this needs to be positive. By knowing and understanding this edge, we are able to continually execute trades as they present themselves, trusting in the long-term outcome of our edge and knowing that it will deliver positive results if we continue to execute trades according to the rules of our trading plan. Even discretionary traders need to know their win rate and their payoff ratios, to enable them to understand the probabilities of their method.

5. Having an opinion and attempting to predict future price direction

We should never fool ourselves that we ‘know’ what the market is going to do and attempt to predict price moves. With the huge number of participants and variables affecting the market (and constantly changing), it is impossible for anyone to predict what prices will do. We need a set of rules or guidelines, fundamental or technical, that enable us to react to price moves and ‘go with the flow' - rather than wasting time, effort and energy trying to make predictions.

6. Not taking responsibility for our decisions

No one makes us become a trader or investor. We choose to do it in an attempt to generate profits from the opportunities the sharemarket presents. We must accept that all the decisions we make are ours alone. We can congratulate ourselves when we make profits and when we stick to the rules, even when we have losing trades. Equally though, we must take full responsibility when we make mistakes and/or have losing trades. There is no point blaming the tipster or the broker: it was your decision to take the advice.

7. Placing too much emphasis on money

Particularly when starting out, new traders and investors tend to focus on ‘making money’; their emphasis places too much importance on the outcome of each individual trade. They want every trade to be a winner (which it can’t) and they are distraught when they have a loss or string of losing trades. A far better emphasis is to detach yourself from the outcome of individual trades and focus on the process of executing each trading opportunity as it comes along, according to the entry criteria documented in your trading plan.

8. Trading the noise

Perhaps one of the greatest traps for traders and investors is listening to the market ‘noise’ and attempting to trade off this information. This noise includes everything from newspaper reports, television news, countless TV shows devoted to the markets, and any other source of information that provides information after the event. All this noise does is distract you from your trading plan and help to confuse and muddy your decision-making processes.

9. Trivialising money management

Two of the most important aspects of trading are risk management and money management. These intertwined areas include such factors as position sizing, the setting of stop-loss and other exit points, portfolio risk boundaries, and understanding the probabilities of your ‘edge’. All too often these aspects of trading and investing are given lip service or neglected completely. You must know and understand how to manage trade position sizes and trade and portfolio risk, because these will be the biggest determining factors of overall performance, far more than entry criteria.

10. Not having a measure of performance

Puddling around in the markets buying and selling a few shares here and there may be a bit of fun and provide something extra to do. But to justify the time and effort put into our trading and investing endeavours, there needs to be a way to measure performance, to ensure it is all worthwhile – there is a suitable return. For share traders and investors, a useful comparison is the All Ordinaries Accumulation Index. After all, if your efforts are not outperforming this index you may as well invest your money in a managed fund and let someone else do all the work.

About the author

Gary Stone is the founder of the 16-year-old business Share Wealth Systems (formerly ShareFinder) and is the designer of three commercially available trading methodologies, the best-known being the SPA3 system. He is a trader and continues to research the markets. He is a regular contributor to Sky News Business, ABC Radio, ATAA meetings and conferences, ASX Investor Update and Your Trading Edge magazine. Register for a free trading DVD.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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