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Diversify, Diversify, Diversify

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  • Diversify, Diversify, Diversify

    Diversification, even in trading, is very important for risk reduction. Since you aren't going to be correct in every trade you make, diversification is necessary and important as a means to risk reduction and capital preservation.

    The simple fact is this: if you put all your trading capital in one or a very limited number of stocks, you are just asking for trouble and increasing the risk you are exposing your money to. At some point, if you trade long enough, you will undergo owning a stock that drops like a rock for one reason or another. Most people who have traded for any length of time have been there, and it's no fun at all. Avoiding putting all of your eggs in one basket is the first step in limiting risk when it comes to both investing and trading.

    It is important to avoid investing too much in a position. There is an old story on Wall Street where one trader asks another trader for advice. He says, "I've bought so much of this stock that I can't get any sleep at night... what should I do?" His friend says, "Reduce your position in the stock down to the sleeping point." This is not only very good advice, but very true. The smart trader takes up no position in such large quantities that it makes him overly nervous or subjects him to loss of sleep.

    Trade at levels which you can afford, and you will generally feel much more comfortable in your trading. This will generally result in much clearer thinking and smarter decisions on your part. Too much risk will result in too much fear, and that will cloud your thinking and judgment.

    Trade stocks that you know. Part of being confident about a position you take up relates to having some understanding of the company behind the stock. Clearly it is impossible to know every little detail about the day-to-day operation of every business you buy stock in. However, it does help if you have a basic understanding of the type of business they are in and how news (positive or negative) may relate to and/or impact a company and their stock. This will not only help you feel more comfortable about the position you take up, but it will allow you to more quickly evaluate news which may be released regarding the company.

    Trade stocks you know or that are in areas you may have experience in. Warren Buffett is a good example of this philosophy. He has no problem telling share holders in his investment companies that he doesn't understand much about technology related companies and therefore steers clear of buying such stocks. Sticking to what you know is not only a good way to start out investing and trading stocks, but it can help you feel more confident and make better decisions along the way.

    Another approach is to trade popular/liquid stocks. Stocks that are "popular" with the public and investment community have a very real benefit to your trading. Specifically, they tend to be very liquid. Liquidity is a measure of how much volume changes hands on a specific stock (typically on a daily basis). The more liquid the stock is (i.e. the more shares it trades) the more likely you'll get a fair price when buying or selling the stock. Also, the more likely it is that there will be a market to buy from or sell into.

    Trading stocks which have very low volume (typically under 100,000 shares per day) can incur additional costs and can limit your ability to get in and out quickly when so desired. Often times if you try to buy or sell a large block of stock, there simply won't be a market at current prices. This can result in the market "stepping away" from you when you go to sell. Worse yet, you can drive the price up on yourself. While there are times when buying a little known stock may work out, for most of your trading, you should strongly consider sticking to actively traded stocks. This is true of options trading as well (i.e. stick to options on stocks which trade higher volume).

    Trade stocks that are making money. The stock market is based largely on economics and business (with some emotion and perception thrown in). As a result, I personally feel it's a good idea to trade stocks on companies which are currently showing a profit, as opposed to companies which "might show a profit someday". Great ideas are a dime a dozen, as they say, and you don't have to look far on Wall Street to find stock in companies that are using other peoples' money to test out their "great" idea. In my personal opinion, I would much rather be trading stocks in companies that are currently profitable.

    Additionally, keep in mind that even companies that are "making money" on the top line may not be "profitable" from a net (bottom line) profit standpoint. There are many companies out there that have racked up a tremendous amount of debt and/or have business models that, while they bring in quite a bit of cash, are unable to actually show a profit at the end of the year. Generally speaking, stocks which are currently showing a profit or are very close and very likely to show a profit in the near term, trade better and are somewhat less risky than stocks which are either in the red or struggling to show profits on their financial statements.

    Part of this is because valuations are much easier to calculate from real earnings (i.e. using the company's P/E ratio) than trying to base valuations on "what might happen" down the road. True, sometimes stocks trade more actively or more wildly on news of potential profits, but at the same time, when a company announces they may not meet analysts' expectations or may experience an earnings short fall, it can get quite dangerous. Consider sticking to companies with tangible, consistent earnings when doing your trading as a further means to risk reduction.

    Finally, avoid buying the "Big Event." This idea tends to go hand in hand with the ideas presented above (regarding trading companies that actually are able to show a profit). In the stock market, there is always "some big event" that might take place for a company or the market. Buying or selling based on the possibility that this event may take place (or may not take place) or based on the how the market might react to such an event tends to turn your trading into a gamble more than anything else - and this is very risky.

    Buying a stock ahead of what might be a "big event" can be quite risky and often times tends to delay your trading. Very often these big events (such as mergers, buyouts, etc.) get delayed for months and months. If you wish to hold a stock for weeks and weeks or months and months waiting for some big news flash, then that's perfectly okay. However, just keep in mind that generally stocks move up on news far before the average individual hears about even the rumor of the news. As a result, you often see stocks trade down on positive news (due to the fact that the news was already anticipated long in advance and largely priced into the stock prior to the release of the actual news). Generally speaking, buying the big event will tend to be not only risky, but also will tend to slow down and stagnate your trading. Avoid them when possible.

    Good luck in the markets!

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    "Step into the arena and hold on to your hat. Don't get discouraged if you don't make 8 trillion dollars in your first month. Trading is not a get rich quick scheme. Realize that trading is a skill and just like any other skill it takes time to learn. Have convictions in your decisions in life and trading. Ignore the comments and "advice" of those that have never traded a day in their life."

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