Trading Psychology 101

PORTFOLIO POINT: Keeping your head in a volatile share environment means sticking to six simple rules.

Trading for fun and profit in a volatile sharemarket like the one we have at the moment can be tricky: it requires adhering to a set of rules to avoid damage to your psyche and bank balance. Here are the rules that allow me to sleep at night during such difficult times.

1. Your first loss is your best loss

Recently I met a Eureka Report subscriber who asked me what I thought should be done with iron ore hopeful Brockman Resources Limited (BRM). For those unfamiliar with the stock, Brockman is now majority owned by Hong Kong-listed holding company Wah Nam International after it launched scrip bids for both BRM and fellow iron ore explorer Ferraus Limited (FRS).

While Wah Nam succeeded in taking control of BRM, it failed in its pursuit of FRS after the latter company negotiated a friendly bid from Atlas Iron Limited (AGO). As a result of this, BRM's asset is now potentially stranded from necessary transport infrastructure, and minority shareholders in the company, like my questioner, are wondering just what will happen under Wah Nam's control.

I reminded the BRM shareholder that I had recommended selling out of the company a number of times soon after the Wah Nam bid appeared. Sadly, this investor hadn't followed my advice, because to do so at the time would have resulted in a relatively small loss on his BRM position. Now that loss is substantially greater, and that much harder to take. Because big funds in the sharemarket often take a while to react to bad news, nimble investors who recognise such information for what it is can exit their positions well before the vast bulk of selling hits the market and drags the price down even further.

2. Your stocks owe you nothing

Many times I have encountered traders and investors who refuse to sell an underperforming stock because it “owes” them a particular price (usually well above its current price). Unlike shareholders, shares themselves have no memory where they've been in terms of previous price performance.

The solution to this frequently encountered trading impasse is to reassess your portfolio on a regular basis while thinking not where certain shares have been, but where they'll go. Investors in News Corporation (NWS), for example, are currently being forced to consider this issue as it becomes increasingly clear that the short and medium term future of the company may look very different to its past.

3. Would you buy it if you didn’t own it?

This question is one that traders and investors should always ask themselves if a stock in their portfolio isn't behaving as expected. To return again to the News Corporation example, shareholders in the beleaguered media giant should question whether – if they had a pile of cash and a clean sheet of paper when it came to portfolio construction – would News Corporation qualify for inclusion? If the answer to this question is a resounding No, then selling any pre-existing positions makes a great deal of sense.

4. I don’t want to pay capital gains tax

Financial advisers often advise against selling long-held positions due to a desire to avoid capital gains tax (CGT). This argument only makes sense for underperforming positions if you're confident that the underlying company will be OK in the long run. Ten years ago plenty of dotcom investors avoid crystallising substantial gains to reduce CGT, only to see their paper profits evaporate to nothing after the “tech-wreck” that began in March 2000.

5. Transfers to the infamous 'bottom drawer’

Another common (and incorrect) reaction to underperforming trading positions is to reclassify them as long-term investments to be ignored for the moment and dumped into the “bottom drawer” (or even more stupidly, the super fund!). Admitting when you're wrong in an argument, a traffic accident or a trading position is a very hard thing to do but it's essential for investors who want to preserve their capital during a volatile and generally negative sharemarket. Developing such a capability also pays big dividends when it comes to solving domestic disputes; just admit you're wrong and get on with life!

6. Taking advice you don’t like

Anybody who works in the sharemarket will have been approached at a social gathering an asked, "So, what's your opinion on XYZ Limited?" Sometimes the questioner is genuinely seeking your opinion on a stock ahead of a possible purchase. Most times, however, they already hold the stock and are seeking positive reinforcement about their decision.

If your answer is that you’d give the stock a wide berth, nine times out of 10 the investor will automatically discount your opinion as unworthy and ignore it, while at the same time seeking out those who also own XYZ Limited and who therefore might have something more positive to say. While it's nice to sit among supporters of your own team at the football, in the sharemarket you should do the exact opposite and seek out opinions contrary to your own as often as you can.

Although there's nothing secret about the above trading tips, in my experience it's extraordinarily difficult for investors to follow them as religiously as they should. This is because whether we like it or not, we are all creatures of emotion, especially during times of great tension – such as when money is being lost on the sharemarket. Just remember that you don't always have to trade, especially in difficult times – which we're undoubtedly experiencing right now. Going completely to cash for a while can be a wonderful thing for investors suffering from lack of sleep.

Tom Elliott is managing director of MM&E Capital.