So far the Apprenticed Investor series has discussed a lot of don'ts. Don't do this, don't do that; avoid talking to these kinds of traders; don't say or think these kinds of things. Well, it's time to shift gears, and since trading is an active enterprise, I'll discuss some things you should do. I plan to expand on these ideas significantly in future episodes. Taken together, the following 10 rules will not only help you with the philosophical grounding necessary for thoughtful -- and successful -- investing, they will help you avoid some of the more common mistakes made by investors and traders early in their careers. This is the "Zen of Trading;" It is more than an overview -- it's an investment philosophy that can help you develop an investing framework of your own.
- 1. Have a Comprehensive Plan: Whether you are an investor or active trader, you must have a plan. Too many investors have no strategy at all -- they merely react to each twitch of the market on the fly. If you fail to plan, goes the saying, then you plan to fail. Consider how Roger Clemens approaches a game. He studies his opponent, constructs his game plan and goes to work. Investors should write up a business plan, as if they were asking a Venture Capitalist for start-up money; just because you are the angel investor doesn't mean you should skip the planning stages.
- 2. Expect to Be Wrong: We've discussed
- 3. Predetermine Stops Before Opening Any Position: Sign a "prenuptial agreement" with every stock you participate in: When it hits some point you have determined before you purchased it, that's it, you're out, end of story. Once you have come to understand that you will be frequently wrong, it becomes much easier to use stop-losses and sell targets. This is true regardless of your methodology: It may be below support or beneath a moving average, or perhaps you prefer a specific percentage amount. Some people use the prior month's low. But whatever your stop-loss method is, stick to it religiously. Why? The prenup means you are making the exit decision before you are in a trade -- while you are still neutral and objective.
- 4. Follow Discipline Religiously: The greatest rules in the world are worthless if you do not have the personal discipline to see them through. I can recall every single time I broke a trading rule of my own, and it invariably cost me money. RealMoney's Chartman, Gary B. Smith, slavishly follows his discipline, and he notes that every time some hedge fund -- chock full of Nobel Laureates and Ivy League whiz kids -- blows up, the mea culpa is the same: If only we hadn't overrode the system. In Jack Schwager's seminal book Market Wizards, the single most important theme repeated by each of the wizards was the importance of discipline.
- 5. Keep Your Emotion In Check: Emotion is the enemy of investors, and that's why you must have a methodology that relies on objective data points, and not gut instinct. The purpose of Rules 1, 2 and 3 is to eliminate the impact of the natural human response to stress -- fear and panic -- and to avoid the flip side of the coin -- greed. Remember, we, as a species, were never "hard-wired" for the capital markets. Our instinctive "fight or flight response" did not evolve to deal with crossing moving averages or CEOs resigning or restated earnings. This evolutionary emotional baggage is why we want to sell at the bottom and chase stocks at the top. The money-making trade -- buying when there's blood in the streets, and selling when everyone else is clamoring to buy -- goes against every instinct you have. It requires a detached objectivity simply not possible when trading on emotion.
- 6. Take Responsibility: Many folks believe "the game is fixed." To them, I say: get over it. Stop whining and take the proper
- 7. Constantly Improve: Investing is
- 8. Change Is Constant: Heraclitus was a Greek philosopher best known for his "Doctrine of Flux": "The only constant is change." That doctrine is especially true in the markets. Therefore, as you constantly upgrade your skills, you must remain supple enough to adapt to an ever-changing field of play. Human nature -- especially in herds -- is unchanging. But these behaviors must be contemplated within their larger context. Add a new element -- PCs, lower trading costs, the Internet, vast amounts of cheap data, even CNBC -- and you introduce a new factor that impacts all the players on the field. As conditions change, you must decipher how they impact your strategy, your emotions and your trading -- and adjust accordingly.
- 9. Learn to Short/Hedge Stocks: Short is not a four-letter word. Successful traders learn to play both sides of the fence. That's less controversial today than it was as the market was first falling apart, but it is no less true. When a particular strategy isn't working, the market is telling you something. Thoughtful traders must consider whether there are bigger issues than their own trading mechanics when they enter a losing streak. In Law School, students learn they have to be ready to argue either side of a case. You never truly knew a case until you could argue both for and against it. Only when you were able to see its warts could you truly appreciate the beauty. The trading corollary is that you should never own a stock unless you know what makes it an attractive short. Each buy and sell decision should be an argument pro and con. The market is cyclical; count on a bear market every four years or so. Unless you plan on sitting out for 18 to 24 months once or twice each decade -- as much as four years out of 10 -- you better learn to either short stocks or hedge long positions.
- 10. Understand Sector Strength and Market Trend: This rule generates the most "pushback" of any on the list, because it's so counter-intuitive: Stock selection matters less than you think. Studies have convincingly demonstrated that about 30% of a stock's progress is determined by the company itself; a stock's sector is equal to at least another 30% (if not more). The overall direction of the market is an even bigger factor, counting for some 40%. If you own the best company in the wrong sector, or buy the greatest stock when the broader market is going the other way -- both positions are likely to be losers. But if you see a strong sector, the market trend will help out even the weakest stock in the bunch.
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 | 1. | Expect to Be Wrong | | 2. | Your Fault, Reader |
| 3. | The Wrong Crowd | | 4. | Bull or Bear? Neither |
| 5. | Know Thyself | | 6. | Prepare for Battle |
| 7. | Bite Your Tongue | | 8. | Don't Speak, Part 2 |
| 9. | The Zen of Trading | | 10. | The Folly of Forecasting |
| 11. | Lose the News | | 12. | Tracking Elephants, Pt 1 |
| 13. | Tracking Elephants, Pt 2 | | 14. | Nothing Doing |
| 15. | Surviving Silly Season | | ||
| Check back for more of Barry Ritholtz's Apprenticed Investor series | |||||
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