Traditional mutual fund and ETF investors can learn a lot from traders, more than I first imagined.
I’m a long-term investor myself and abide by an ethics policy that makes it impossible for me to pursue short-term trading strategies in order to avoid potential conflicts of interest, but the more I work with traders the more I have come to appreciate how they do their jobs.
But just over a month ago, I detailed five things that long-term buy-and-holders should learn from short-term traders, a list gleaned from a few months as editor at RagingBull.com, where veteran traders write about their day- and swing-trading strategies. I’m still not suggesting that average long-term investors become day- or swing-traders – too many studies show that fund investors are better off buying-and-holding a slowly-evolving asset allocation than trading even semi-annually – but there’s no doubt in my mind that the tenets of successful traders will improve their investment process and results.
After talking about the importance of “trading the plan,” “using the right tool for the job,” “quantifying risk and reward” and more, it became clear – with some help due to a few traders who also buy-and-hold the core of their portfolio – that I hadn’t gone far enough. Thus, here are four more ways that long-term buy-and-holders will become better investors by emulating short-term traders:
Understand the size of the trade.
Traders carefully consider the size of their position in any one investment because they can be wiped out if they risk too much, and they won’t achieve sufficient growth if they risk too little.
Savvy traders risk 1 percent or less of their account in any single trade; their “trade risk” is how much they’re willing to lose if the stock or ETF runs against them.
Say they buy an investment at $10, and set a stop-loss to guard against a mistake that sells if the price falls to $9.50. That potential 50-cents-per-share loss is their “trade risk,” so if they have a portfolio of $50,000 and their maximum risk is 1 percent of their account, they’re only willing to risk losing $500 on the trade.
Traders divide the money at risk (the $500) by the cents at risk (the 50 cents-per-share possible loss) to determine the maximum number of shares they’ll trade.
Long-term fund investors don’t need to size trades this way, but are wise to consider how losses could affect their portfolio; the math would encourage them to diversify and rebalance their portfolios regularly.
Don’t worry about break-even.
One of the worst things I ever hear from fund investors stuck with a bad fund is “I’m waiting to get back to break-even,” as if the goal isn’t to make money but rather not to lose it.
If you’re stuck with a laggard or a loser, you may recover losses faster by selling out and buying a new fund than by waiting for a dullard to stumble back to the starting line.
Worse yet, many fund investors see a recovery to break-even as a reason to expect performance to improve; this is how bad funds stay in investment portfolios for decades.
If breaking even isn’t your goal, then – as noted in the first five trading concepts I wrote about – accept your mistakes and move on.
Evaluate securities based on where they are now and what’s happening next.
Beyond avoiding the stigma of break-even thinking, traders evaluate their holdings based on what is happening now and what they see as happening next. They are always looking forward.
Most buy-and-holders, however, use past performance as their primary buying criteria, and are willing to hang on so long as the performance numbers meet their definition of “acceptable.” The problem is that they are driving forward while keeping their attention focused in the rear-view mirror.
Fund investors always should evaluate funds with an eye towards whether they are appropriate for current and future market conditions, rather than based on what they have done in the past.
Have your standards and stick with them.
Traders have bedrock concepts they believe in. For example, many day traders want to make sure that the industry trend is running in the direction they see for an individual stock for the industry. Thus, if they expect a stock to be rising, but the ETF for the industry is trending down, they stay on the sidelines.
One trader explained it to me as wanting “all green lights.” If all systems aren’t a go, there is no lift-off.
Too many buy-and-hold fund investors stick with funds where independent ratings have changed, expense ratios have increased and more. They buy funds that look “mostly” good rather than finding issues that meet all of their criteria.
Buying something that pushes all of your hot buttons give you something to believe in, which always delivers better long-term results than sticking with something where your feelings are lukewarm.
Chuck Jaffe is editor at RagingBull.com; he a nationally syndicated financial columnist and the host of “MoneyLife with Chuck Jaffe” (moneylifeshow.com). He is a long-term investor and does no short-term trading of stocks, options or ETFs. You can reach him at email@example.com.
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