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Stock Trading Lesson – Fix the Problem

This is the second part of a two part post.

In my last post, I was relating a true life story of one of my students I mentor. Click here to read part 1 of this true stock trading lesson. I recommend you do so, if you haven’t already.

After two years, my student feels he is ready to fly on his own and shared his trading strategy with me. No matter how hard I tried to get him to see the flaws, he thinks it is perfect. In this post, I want to discuss what is wrong with his strategy, and how it can be improved. Perhaps you can us the info to help create a strategy for yourself or to find flaws in your current strategy.

So lets get started on his rules and see whats wrong with them.

Rule 1) Buy mutual funds only.
While mutual funds provide some safety (compared to individual stocks) and diversity, they pretty much all go down when the markets go down. At least with stocks, 25% of them rise in bad markets. Index ETF’s are even better. They offer diversity, and you can profit on them even in down markets. They also offer leveraged ETF’s for bigger gains (and losses if you are no careful).

Rule 2) Buy only 3 or 4 star funds.
Again, like I said for rule 1, all 3 and 4 star funds will go down when markets go down. This offers no protection in down markets.

Rule 3) Check for great past performance recorded and has good present performance in the YTD %.
This rule is too vague. After applying it, you are still left with hundreds of funds. Also, what makes a “great” performance? More than likely he will just “guess” which one of the hundreds left he will invest in. This is a true disaster waiting to happen.

In a bull market like we are in now, he gets excited to hear his fund did 10%. However, the markets went up 20%. In reality, he is losing. No matter how hard I try to explain this to him, he is elated to get 10%, much more than the 1% he was getting in a savings.

The lesson here is, he is leaving money on the table by not have a definitive set of rules that gets him into the best performers.

Rule 4) Never sell for a loss. If the fund drops right away, hold it until it goes back above the purchase price, no matter how long that may take.In 2000, tech stocks were all the craze. The party didn’t last long and tech stocks crashed. It took 14 years for them to get back to their old highs. How would you like to hold something for 14 years and still not have a return on your investment? That’s what this rul can do to a person.

You need to be able to keep losses small, cut the losses and put your funds into something that IS going up.

In conclusion: Making up rules for a trading strategy is fine, but if you don’t backtest them (you go back 20 years or so and run your strategy on the data and see if it shows a profit year after year) you won’t know if your strategy is profitable. If it is profitable, you need to know the rate of return so that you can compare to other strategies you may have and put your money where it gets the best return.

My student failed to backtest. He tried it once, it worked in a bull market (although he did no comparisons to the market or other strategies to see if he beat them), and he has never tested his strategy in sideways or bear market.

If he doesn’t learn from this stock trading lesson, he’s bound to lose a good portion of his trading funds and give up altogether, claiming it too hard to make money in the markets.

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