“Most Traders Lose Money in the Stock Markets”
And what can you do to secure your financial freedom through the stock markets?
“My friend has made a neat profit in a Bitcoin Trade; I shouldn’t be left behind.”
“My broker says that this stock is hot and I can make a quick buck if I buy it now.”
These are the kind of motivations that drive many people into entering the stock market. Unfortunately, most don’t understand the working of the market. This is what leads to around ninety per cent of active day traders losing money. The market is unforgiving to people who come unprepared.
“So what really is the market?”
The market is the total of all entities put together. On one end of the spectrum are the institutions and these are the professionals. They understand the game. The other end carries the next door Jhon, who doesn’t have a clue, about how the game works. Betting against the institutions might be like playing basketball, against Micheal Jordon.
Now that doesn’t mean that our next-door Jhon has no chance. If Jhon defines his investment or trading horizon, gains a basic understanding of the market, knows his limits and has a system in place, he can surely win in the markets.
Like any other skill, trading or investing requires time and effort. Getting into the market without developing the necessary skills is like performing surgery without getting a medical degree. On the contrary, if you develop the necessary skills, you will be looking at generating a consistent additional income. From a long term standpoint, your investments will make money, while the World sleeps.
There are five basic tenets, that can help you to navigate the rough rides of the market, smoothly:
1. Define your Investment Horizon:
You need to be clear about your investment horizon before jumping into purchasing a stock. Jhon, purchased a stock just to make a quick profit and when the stock price tumbled down, he was clueless. He didn't want to book a loss and began justifying the trade by looking for positive stories. And when the stock went down further, he dug deep into the financial reports of the company and tried to look for justifications. A year down the line, Jhon continues holding this stock and has now become a long term investor in the company. There has been a clear shift in the investment horizon of Jhon. He turned into a long term investor from a short term trader and has ended up blocking his capital on a dud for years. This is because he was not clear about his investment horizon, at the beginning.
Investment horizons are extremely important and it is here that most of the new participants make mistakes. The process of picking a stock for short term trades is completely different from that of long term investments. You simply cannot mix the two of them.
So, before taking any position check your investment horizon.
2. Technical or Fundamental Analysis?
Now that Jhon has learned from his mistake, he needs to clearly separate his long term investment portfolio from the short term positional trades.
But first, he needs to build the necessary capabilities. There are two powerful systems that every serious market participant needs to equip himself with. These are the Technical Analysis(TA) and the Fundamental Analysis(FA).
Technical Analysis:
Technical Analysis is a fancy name for the study of the price movement of stocks and indices. Technical Analysts or Technicians as they are called, swear by this discipline. Some of them can tell you, where the stock price will go, by just looking at the price charts and knowing nothing else about the company.
There is a certain way the prices of stocks move and the basic principles of those movements are captured by TA. The Dow Theory is the foundation of TA. If you understand just the Dow theory you will be better equipped to handle the roller coaster ride of the stock markets. Looking at multiple timeframe charts ranging from monthly to hourly gives you a holistic picture of how a stock or an index moves. Basis this you can identify a trend. Your ability to identify an uptrend or a downtrend will define your success in the market. Also, understanding, where stock prices take to support or face resistance, is critical for taking any positional trades. Other useful indicators like the MACD and RSI help in identifying the change in direction of a stock price and ascertain whether the market is in overbought or oversold territory.
There are hundreds of indicator setups but just focus on a few. Keep your charts simple and avoid clutter. TA works for long term investing but is an indispensable skill when it comes to short term trading. Getting into the markets without equipping yourself with TA is like going to hunt lions with your bare hands. You will only get mauled.
Fundamental Analysis:
This is the holy grail of a long term investor like Warren Buffet. Fundamental Analysis looks at the factors that could influence the price of a stock or an asset and extensively uses financial statements like the Balance sheets and the P&L reports. It also involves the study of the macro factors that can influence the value of a stock. It gives you an idea of how a company has performed and what is the outlook for the future. Now, this stuff is a little complicated and is supposedly the domain of the fund managers who promise you those hefty returns.
To keep things simple, you could follow the below rules while investing in the long term:
i. Make the biggest investments in sectors or industries where you have a deep understanding.
Why? Put your money where your mouth is. If you understand the nuts and bolts of your industry you will know which companies to invest in.
ii. If you do not understand any of the sectors or industries, simply put your money in an index fund or an ETF that tracks a broader index like the S&P 500 or the Dow.
Why?: 90% of the big shot fund managers have a track record of underperforming the index. It saves you’re the high fees that they charge while delivering better returns.
iii. Get a basic understanding of the financial statements and ratios.
Why? The Financial Data of a company helps us in understanding its track record and build future models.
iv. Look at the prospects of the stock and not just the past.
Why? The market is always forward-looking. What has happened in the past has been priced in.
Technical or Fundamental Analysis may sound intimidating but you need to learn at least the basics if you are putting your money on the line.
3. Define your System and Risk-Reward before entering the market.
You have learned TA or Fundamental Analysis and have evolved a system for making investments or trades.
But wait! the market can still move against you.
This is where you need to have a money management system in place. You need to document the price at which you have purchased the stock and also the price at which you are going to book a profit or a loss. This before entering the market. If you are a short term trader a 2:1 risk-reward ratio is good enough. The ratio needs to be much wider in the case of long term trades. This is because prices fluctuate widely over a longer period of time. In any case, a stock losing more than 20% over a period of time needs to be viewed with suspicion and its presence within your portfolio needs to be questioned.
You need to maintain a journal of your trades, clearly defining your entries and exits and the reasons. Your system could be based on technical or fundamental factors. Today, there are platforms, that will enable you to automate your strategies, after you have carefully backtested them, with years of data. If you don’t have a system in place, it is likely, that you will meander aimlessly in the market losing your shirt in the process.
4. Leverage can Kill you.
A lot of new participants enter the market via the futures and options route or buy and sell leveraged products provided by their broker. Over leverage can be dangerous. It enables you to buy or sell beyond your means and can clean up your account if the trade goes against you. The fundamental rule is not to take any position where your maximum loss can exceed 3–5% of your account value.
Taking positions that are beyond your loss taking capacity can also play with your psychology and can prompt you to make decisions that are counterproductive. There has been this craze among Robinhood investors to buy Options. While buying options can work in a trending market it can clean you up during normal times. We need to understand that Options are instruments that expire worthless if the market movements are limited. Options are a great way of profiting from the market but you need to understand options greeks and basic strategies associated with these before venturing into them.
5. It is all about Psychology.
The market is a great teacher because it gives you valuable lessons about two primal human emotions, namely greed and fear. When you see money being made in a position your ego gets a flip and you start crediting the success to your Buffett like stock picking ability. Similarly, when you lose, you blame bad luck. At times you blame yourself for closing a winning trade too soon or not taking a trade that you always knew would do well. You stick with preconceived notions and avoid losses to the point of getting paralysed into inaction.
The market helps you in understanding your inner self. That is why there is a completely new discipline of behavioural finance that has taken over the investment circles. You need to train yourself psychologically if you want to participate. It also helps you evolve as a more mature and balanced person.
In conclusion
The markets can help generate a steady income provided you understand them and develop the necessary technical and psychological skills. I have come across ordinary investors and traders who have developed the requisite skills and now earn more than what the best writers on Medium can only dream of. I am not saying that you stop writing on medium but you should develop new skills which can add to your financial well being.
It is not easy but as they say, a journey of thousand miles always starts with the first step.
