Finding Fortune In Foreign-Stock ETFs

The foreign equity asset class is an area that many investors neglect to consider for their portfolios. Unfortunately, by ignoring the opportunities outside of U.S. borders, investors are giving up a chance to increase their portfolio returns. The biggest benefit is not the potential for higher returns, but rather the lowered risk that this type of diversification provides. 

Add in the hedge against a weak U.S. dollar, and foreign investments become essential for nearly all investors - regardless of individual tolerance. One way to invest in foreign markets is through foreign exchange-traded funds (ETFs). Read on to learn about foreign-stock ETFs and how they can help you to diversify your portfolio, combat the effects of a weak U.S. dollar and, if you choose carefully, increase your portfolio's risk/reward ratio. 

Foreign-Stock ETFs and U.S. Markets

The introduction of ETFs that concentrate primarily on overseas investments has opened a new door of opportunity for investors. Instead of relying on their stock-picking skills, investors now have the option of investing in specific countries or regions of the world. This type of investing is also different because rather than using the bottom-up approach that many investors implement when picking individual stocks, the best way to choose the appropriate foreign-stock ETF is a top-down method. 

Since the start of this century, America's role as a leader in world economic growth has diminished as a number of other countries step to the front of the line. The two countries that most investors think of when they are searching for growth are China and India. With real gross domestic product growth rates well above U.S. rates, it is only natural for the stock markets to join in the expansion as investors seek out high-growth opportunities. This process allowed foreign markets to grow while U.S. market growth slowed and, consequently, may have caused some losses in U.S. markets.

When growth in the U.S. slowed in the early 2000s, the stock market was directly affected. During the first six years of the twenty-first century, the S&P 500 averaged a loss of 1.4% annually, thanks in large part to slowing growth. During the same time frame there were a number of countries that produced sizable annual gains. One of the leaders was the Australian ASX All Ordinaries Index, which had an annual gain of 7.5% between 2000 and 2005. 

This negative correlation between the Australian and U.S. stock markets is one of the primary benefits of investing in foreign-stock ETFs because when markets move opposite to one another, by investing in both markets, investors achieve greater diversification and protection from risk. 

Foreign Economic Risk Factors

Other factors to consider when choosing specific foreign-stock ETFs for your portfolio include country-specific risk and the risks involved with investing in emerging versus developed countries. All country-specific ETFs will carry significant country-specific risk. This means that the performance of the investment will be very dependent on the country's overall stage of political and economic development. 

Investors can reduce country-specific risk by choosing an ETF that invests in an entire region, rather than one particular country. For example, instead of investing in a Brazilian ETF, an investor could opt for lower risk by investing in an ETF that encompasses a number of South American countries. 

The level of risk that investors take on will also be determined by whether they invest in ETFs that focus on developed countries or ETFs that focus on emerging-market countries. Historically, developed countries have not grown as quickly as emerging-market countries and, therefore, ETFs from developed countries are generally regarded as more conservative.

For most investors, an appropriate mix of emerging-market and developed-country ETFs depends on risk tolerance. Investors who are less willing to take on risk would probably be more comfortable with investing in fewer emerging country ETFs and vice versa. 

Hedging Against a Weak Greenback

After reaching its peak in 2001, the U.S. Dollar Index began breaking down - a weakness that, in 2006, has yet to subside. With an increasing federal budget deficit and current account deficit, it appears that the greenback will continue its long-term downtrend. If this trend continues, investors may want to hedge their portfolios against it by investing in foreign-stock ETFs. This strategy will allow investors to take advantage of the decline of the U.S. dollar, which has resulted in a boost in profits for companies based outside the U.S.

The commodity sector is another area that has been able to profit from a weak U.S. dollar. A number of the large commodity companies based overseas are held by foreign-stock ETFs. For example, iShares MSCI Brazil Index ETF(EWZ) has more than 50% of its assets in commodity-related stocks. From 2002 to 2005 this ETF was one of the best performing ETFs as commodities boomed and the U.S. dollar fell. Canada is another country rich in natural resources that has benefited from the commodity boom and weak greenback. 

The iShares MSCI Canada Index ETF (EWC) boasts returns of more than three times those seen on the S&P 500 between 2002 and 2005. These examples suggest that successful ETFs can be found in both developed and emerging countries (Brazil is considered a moderately risky, emerging-market country whereas Canada is more conservative and already economically developed). This is where asset allocation and diversification become important in selecting the appropriate ETFs for your portfolio.

Specific Foreign-Stock ETFs

Interestingly enough, from the start of the year 2000 through the end of 2005, the strongest performing ETFs were concentrated in several regions of the world. However, none of these ETFs were associated with the U.S. In fact, the top four ETFs had ties to emerging countries located in Eastern Europe. 

The Templeton Russia and Eastern European Fund (TRF), an actively managed closed-end fund, led the way with a gain of more than 200%. The only country-specific ETF in the top five was the iShares MSCI Austria Index ETF (EWO). Because Austria is considered to be more stable than most of Eastern Europe, EWO is seen as a "gateway" into the emerging region and a lower-risk option for investing in a somewhat volatile area.

Looking at the rest of the decade, there were a number of regions throughout the world with the potential to outperform the U.S. stock market. The Far East has had its moments in the last five years and, overall, it has outpaced the U.S. Investors with a higher risk tolerance may want to look into country-specific ETFs based in countries like Singapore, South Korea and Taiwan. 

Investors with a lower risk tolerance may want to opt for regional ETFs such as the Asia Tigers Fund (GRR), which gives investors exposure to several southeast Asian countries including South Korea, Hong Kong and Taiwan. These types of funds reduce country-specific risk without decreasing returns, resulting in a more attractive risk/reward ratio.

Risks

There are a few negative aspects investors must consider before buying foreign-stock ETFs. The regulations outside the U.S., specifically in emerging countries, can be much more lenient than those imposed on U.S. businesses and could result in unethical business practices, which can threaten investors' returns. 

Geopolitical risk also tends to be more prevalent in foreign countries due to the current tensions throughout the world and there is currency risk associated with companies based overseas that could affect their performance. Finally, volatility can be higher in foreign countries than it is in the U.S. and, therefore, foreign investment may not be appropriate for all investors.

The Bottom Line

For investors, putting some money into foreign investments can present significant advantages. Instead of taking the time and effort to pick individual stocks, a simple way to diversify a portfolio without taking too many positions is by investing in foreign-stock ETFs. The negative correlation between specific countries and the U.S. stock market will help lower a portfolio's overall downside. 

Therefore, if the goal of your portfolio is to increase potential rewards without greatly increasing risk, you must consider foreign-stock ETFs. Keep in mind, however, that the appropriate mix of ETFs from a number of regions is essential in maximizing the risk/reward ratio. 

Tips for investing in stocks

1. Stocks aren't just pieces of paper.

When you buy a share of stock, you are taking a share of ownership in a company. Collectively, the company is owned by all the shareholders, and each share represents a claim on assets and earnings.

2. There are many different kinds of stocks.

The most common ways to divide the market are by company size (measured by market capitalization), sector, and types of growth patterns. Investors may talk about large-cap vs. small-cap stocks, energy vs. technology stocks, or growth vs. value stocks, for example.

3. Stock prices track earnings.

Over the short term, the behavior of the market is based on enthusiasm, fear, rumors and news. Over the long term, though, it is mainly company earnings that determine whether a stock's price will go up, down or sideways.

4. Stocks are your best shot for getting a return over and above the pace of inflation.

Since the end of World War II, through many ups and downs, the average large stock has returned close to 10% a year -- well ahead of inflation, and the return of bonds, real estate and other savings vehicles. As a result, stocks are the best way to save money for long-term goals like retirement.

5. Individual stocks are not the market.

A good stock may go up even when the market is going down, while a stinker can go down even when the market is booming.

6. A great track record does not guarantee strong performance in the future.

Stock prices are based on projections of future earnings. A strong track record bodes well, but even the best companies can slip.

7. You can't tell how expensive a stock is by looking only at its price.

Because a stock's value depends on earnings, a $100 stock can be cheap if the company's earnings prospects are high enough, while a $2 stock can be expensive if earnings potential is dim.

8. Investors compare stock prices to other factors to assess value.

To get a sense of whether a stock is over- or undervalued, investors compare its price to revenue, earnings, cash flow, and other fundamental criteria. Comparing a company's performance expectations to those of its industry is also common -- firms operating in slow-growth industries are judged differently than those whose sectors are more robust.

9. A smart portfolio positioned for long-term growth includes strong stocks from different industries.

As a general rule, it's best to hold stocks from several different industries. That way, if one area of the economy goes into the dumps, you have something to fall back on.

10. It's smarter to buy and hold good stocks than to engage in rapid-fire trading.

The cost of trading has dropped dramatically -- it's easy to find commissions for less than $10 a trade. But there are other costs to trading -- including mark-ups by brokers and higher taxes for short-term trades -- that stack the odds against traders. What's more, active trading requires paying close attention to stock-price fluctuations. That's not so easy to do if you've got a full-time job elsewhere. And it's especially difficult if you are a risk-averse person, in which case the shock of quickly losing a substantial amount of your own money may prove extremely nerve-wracking.

How to Become Wealthy

#1: Change the Way You Think About Money

The general population has a love / hate relationship with wealth. They resent those who have it, but spend their entire lives attempting to get it for themselves. The reason a vast majority of people never accumulate a substantial nest egg is because they don't understand the nature of money or how it works.

Cash, like a person, is a living thing. When you wake up in the morning and go to work, you are selling a product - yourself (or more specifically, your labor). When you realize that every morning your assets wake up and have the same potential to work as you do, you unlock a powerful key in your life. Each dollar you save is like an employee. Over the course of time, the goal is to make your employees work hard, and eventually, they will make enough money to hire more workers (cash). When you have become truly successful, you no longer have to sell your own labor, but can live off of the labor of your assets.

#2: Develop an Understanding of the Power of Small Amounts

The biggest mistake most people make is that they think they have to start with an entire Napoleon-like army. They suffer from the "not enough" mentality; namely that if they aren't making $1,000 or $5,000 investments at a time, they will never become rich. What these people don't realize is that entire armies are built one soldier at a time; so too is their financial arsenal.

A friend of mine once knew a woman who worked as a dishwasher and made her purses out of used liquid detergent bottles. This woman invested and saved everything she had despite it never being more than a few dollars at a time. Now, her portfolio is worth millions upon millions of dollars, all of which was built upon small investments. I am not suggesting you become this frugal, but the lesson is still a valuable one. Do not despise the day of small beginnings!

#3: With Each Dollar You Save, You Are Buying Yourself Freedom

When you put it in these terms, you see how spending $20 here and $40 there can make ahuge difference in the long run. Since money has the ability to work in your place, the more of it you employ, the faster and larger it will grow. Along with more money comes more freedom - the freedom to stay home with your kids, the freedom to retire and travel around the world, or the freedom to quit your job. If you have any source of income, it is possible for you to startbuilding wealth today. It may only be $5 or $10 at a time, but each of those investments is a stone in the foundation of your financial freedom.

#4: You Are Responsible for Where You Are in Your Life

Years ago, a friend told me she didn't want to invest in stocks because she "didn't want to wait ten years to be rich..." she would rather enjoy her money now. The folly with this school of thinking is that the odds are, you are going to be alive in ten years. The question is whether or not you will be better off when you arrive there. Where you are right now is the sum total of the decisions you have made in the past. Why not set the stage for your life in the future right now?

#5: Instead of Buying the Product... Buy the Stock!

Someone once asked me why they weren't wealthy. They always felt like they were putting money aside, yet never seemed to get any further ahead. The answer is simple. I told them to stop buying the products companies sell and start buying the company itself! A survey of America's affluent (those who make over $225,000 a year or own $3,000,000 in assets) revealed that 27-30% of all the income the wealthy earned went into investments and savings. That isn't a result of being rich, that is why they are rich. When the pain of getting out of the bondage of financial slavery is greater than the pain of changing your spending habits, you will become rich. Either change, or be content to live as you are.

The Bond Market: A Look Back

Many retail investors shun the bond market because it can be difficult to understand and it doesn't offer the same level of potential upside as the stock market. While the bond market is different from the stock market, it can't be ignored. Its size (comparable to the stock market) and depth will ensure this never happens. With the help of the book "Triumph Of The Optimists: 101 Years Of Global Investment Returns" (2002), by Elroy Dimson, Paul Marsh and Mike Staunton, we will look at how the global bond market performed over the 20th century and what changes we foresee for it during the 21st.

An Unkind Century for Bond Investors

Equity investors triumphed over bond investors during the 20th century because the risk premium built into bonds during the 1900s was much too low to compensate investors for the forthcoming turmoil that would hit the bond market over the next century. This period saw two secular bear and bull markets in U.S. fixed income, with inflation peaking at the end of the First and Second World Wars as a result of increased government spending during those periods.

The first bull market started after World War I and lasted until after World War II. According to Dimson, Marsh and Staunton, the U.S. government kept bond yields artificially low through the inflationary period of World War II and up to 1951. It wasn't until these restrictions were lifted that the bond market began to reflect the new inflationary environment. For example, from a low of 1.9% in 1951, long-term U.S. bond yields then climbed to a high of nearly 15% by 1981. This was the turning point for the century's second bull market.

The graph below shows real government bond returns for the 20th century. Ironically, while all of the countries listed in the table below showed positive real returns on their equity markets during this period, the same could not be said about their bond markets.

The countries that did show negative real returns were those most affected by the world wars. For example, Germany saw two periods in which fixed income was all but wiped out. During the worst of the two periods, 1922-23, inflation reached an unfathomable 209,000,000,000%! According to "Triumph Of The Optimists," 300 paper mills and 150 printing works with 2,000 presses worked day and night to accommodate the demand for bank notes during this period! In fact, the 20th century had more than one incidence of hyperinflation, but none was as severe as what Germany saw in the early 1920s. 

The graph below contrasts real government bond returns for the first and second half of the 20th century. Notice how the countries that saw their bond markets do very poorly in the first half of the 20th century saw a reversal in their fate in the second half:

While this illustration gives you a good feel for the government bond market, the U.S. corporate bond market, according to Dimson, Marsh and Staunton, fared better as well, and added an average 100 basis points above comparable government bonds over the 20th century. They calculated that roughly half of this difference was related to the default premium (the premium rewarded for taking on default risk). The other half is related to defaults, downgrades and early calls. 

The Bond Market Would Never Be the Same

In the 1970s, the globalization of the world markets began again in earnest. Not since the Gilded Age had the world seen such globalization, and this would really start to have an impact on the bond markets in the 1980s. Until then, retail investors, mutual funds and foreign investors were not a big part of the bond market. According to Daniel Fuss' 2001 article "Fixed Income Management: Past, Present And Future," the bond market would see more development and innovation in the last two decades of the 20th century than it had in the previous two centuries. For example, new asset classes such as inflation-protected securities, asset-backed securities (ABS), mortgage-backed securities, high-yield securities and catastrophe bonds were created. Early investors in these new securities were compensated for taking on the challenge of understanding and pricing them. 

Innovation in the 21st Century

Entering the 21st century, the bond market was coming off its greatest bull market. Long-term bond yields had compressed from a high of nearly 15% in 1981 to 7% by the end of the century, leading to higher bond prices. Innovation in the bond market also increased during the last three decades of the 20th century, and this will likely continue. Furthermore, securitization may be unstoppable, and anything and everything with future material cash flows is open to being turned into an ABS. Health care receivables, mutual fund fees and student loans, for example, are just a few of the areas being developed for the ABS marketplace.

Another likely development is that derivatives will become a bigger part of institutional fixed income, with the use of such instruments as interest-rate futures, interest-rate swaps and credit default swaps. Based on issuance and liquidity, the U.S. and the Eurobond markets will maintain their dominance of the global bond market. As bond market liquidity improves, bond exchange-traded funds (ETFs) will keep on gaining market share. ETFs have the ability to demystify fixed-income investing for the retail client through their tradability and transparency (for example, Barclays iShares website contains daily data on its bond ETFs). Finally, continued strong demand for fixed income by the likes of pension funds will only help accelerate these trends over the next few decades. 

Conclusion

For the most part, investing in fixed income during the past century was not an overly lucrative proposition. As a result, today's fixed-income investor should demand a higher risk premium. If this occurs, it will have important implications for asset allocation decisions. Increased demand for fixed income will only help to further innovation, which has turned this asset class from stodgy to fashionable.

4 Things to Look for in an Investment

New investors are often interested in purchasing a company's stock but are not sure where to begin. These four characteristics should serve as helpful guidelines in your search for a good investment.

1. What is the price of the entire company?

When doing research, it is important that you look at more than just the current share price - you need to look at the price of the entire company. The "cost" of acquiring the entire corporation is called market capitalization (or market cap for short) and is frequently referred to by financial professionals. In short, the market cap is the price of all outstanding shares of common stock multiplied by the quoted price per share at any given moment in time. A business with one million shares outstanding and a stock price of $50 per share would have a market cap of $50 million.

This market capitalization test can help keep you from overpaying for a stock. Consider the case of eBay and General Motors during the heyday of the Internet era. At one point during the boom, eBay had the same market cap as the entire General Motors Corporation. To put that into perspective, in fiscal 2000, General Motors made $3.96 billion dollars in profit, while eBay made only $48.3 million (not including stock option expense!). Yet were you to buy either one, you would have had to pay the same amount. It is almost unbelievable that any sane investor would pay the same price for both companies but the general public was seduced by visions of quick profits and easy cash.

Another useful tool to help gauge the relative cost of a stock is the price to earnings ratio (or p/e ratio for short). It provides a valuable standard of comparison for alternative investment opportunities.

2. Is the company buying back shares?

One of the most important keys to investing is that overall corporate growth is not as important as per-share growth. A company could have the same profit, sales, and revenue for five consecutive years, but create large returns for investors by reducing the total number of outstanding shares.

To put it into simpler terms, think of your investment like a large pizza. Each slice represents one share of stock. Would you rather have part of a pizza that was cut into ten slices or one that was cut into eight slices? The pizza that was only cut into eight parts will have bigger slices with more cheese and toppings.

The same principle is true in business. A shareholder should desire a management that has an active policy of reducing the number of outstanding shares if alternative uses of capital are not as attractive, thus making each investor's stake in the company bigger. When the corporate "pie" is cut into fewer pieces, each share represents a greater percentage ownership in the profits and assets of the business. Tragically, many managements focus on domain building rather than increasing the wealth of shareholders.

3. What are your reasons for investing in the company?

Before you purchase stock in a company, you need to ask yourself why you are interested in investing in that particular opportunity. It is dangerous to fall inlove with a corporation and buy it solely because you feel fondly for its products or people - after all, the best company in the world is a lousy investment if you pay too much for it.

Make sure the fundamentals of the company (current price, profits, good management, etc.) are the only reason you are investing. Anything else is based on your emotions; this leads to speculation rather than intelligent investing. You have to remove your feelings from the equation and select your investments based on the cold, hard data. This requires patience and the willingness to walk away from a potential stock position if it does not appear to be fairly or undervalued.

4. Are you willing to own the stock for the next ten years?

If you aren't willing to buy shares in a company and forget about them for the next ten years, you really have no business owning those shares at all. The simple but painful truth of this is evident on Wall Street every day. Professional money managers attempt to beat the Dow Jones Industrial Average, which is a collection of 30 largely unmanaged stocks. Year after year, they fail to do this. It seems impossible that a portfolio managed by the best minds in finance can't beat an unmanaged portfolio of long-term stocks held indefinitely.

The guaranteed way to success has historically been to select a great company, pay as little as possible for the initial stake, begin a dollar cost averaging program, reinvest the dividendsand leave the position alone for several decades.

Investment Research 101 -- Turning Ideas into Profit

If you have ever wanted to know how to invest in stock, the best place to start is doing your own research. For new investors, this can be daunting. Fortunately, there are a few good places to start. I'll walk you through them.

Public vs. Private

Before one can invest in a business, he must discover if it is public or private. A publicly traded company is one which has shares of stock traded on the open market. Private companies, on the other hand, do not have shares available for public purchase. Private companies may be owned by an individual, a family, a partnership, employees, or a small group of investors.

To illustrate the difference, consider Hershey and Mars, two of the largest candy companies in the world. The late Milton Hershey’s chocolate business is publicly traded on the New York Stock Exchange. An individual investor could take his paycheck and acquire shares in the company, profiting from every Hershey bar or Reese’s peanut butter cup sold. The multi-billion dollar Mars company, however, is still owned by the Mars family. An investor could not buy shares unless the members of the family allowed him to acquire some of their closely held, personal stock.

How does one determine if a company is public or private? The simplest, most effective way to answer this question is to call the company and ask. At the same time, many corporate web sites offer information on their ownership status; rest assured, if you see an “investor relations” section, the company is public. The lack of such a section does not necessarily mean anything. Take, for example, Fruit of the Loom. The undergarment manufacturer is not publicly traded because it is owned by Berkshire Hathaway, Inc. Berkshire, on the other hand, is traded on the New York Stock Exchange. Hence, an investor may be able to indirectly invest in a business entity through a publicly traded parent company.

Ticker Symbol

Once the investor has discovered a company is publicly traded, he must look up the company’s ticker symbol. A ticker symbol is a collection of letters that represent a particular stock on an exchange or the over-the-counter market. Microsoft, for example, is MSFT. Cisco Systems is CSCO. Berkshire Hathaway has two ticker symbols, one for its class A shares (BRKA) and one of the class B shares (BRKB). Coca-Cola is KO. The Washington Post is WPO.

To discover a company’s ticker symbol, the investor can call his broker or go to a site such asYahoo Finance. Once at the main page, he can choose the “symbol lookup” option. The resulting page will allow him to enter the company (or parent company in the case of a subsidiary such as Fruit of the Loom) name.

With the ticker symbol in hand, the investor can return to the main Yahoo Finance page and enter it. After pressing the “get quote” button, he will be taken to a summary page that includes a current quote for one share of the company’s stock, the total market capitalization of the business, recent dividend payment and yield information, the price-to-earnings ratio for the trailing twelve months and other items of interest.

Obtaining Annual Reports, SEC Filings and other Financial Documents

Assuming the figures presented seem promising to the investor, he will most likely wish to acquire a copy of the company’s annual report, proxy statement and 10k. For this, he will find the Internet an excellent source of free, timely information. One of the best resources is Free Edgar, a database of annual reports and SEC filings. Additionally, the investor could contact the shareholder relations department of the company in which he is interested via telephone or web site and request information. The bottom line: Nearly everything you need to know can be found in the annual report, proxy statement, and 10K.

Dividend Reinvestment Programs (DRIPs) and Direct Stock Purchase Plans

If, after careful analysis of the financial statements and business economics, the investor wishes to build up a long-term holding in the company, he may want to consider an automaticdividend reinvestment program and / or a direct stock purchase plan. Both of these are ideal solutions if he desires to begin a dollar cost averaging program into the company; the former will automatically invest his dividends into additional shares of stock while the latter will provide for regularly scheduled deductions from his checking or savings account to purchase shares of the company’s stock without the aid of a broker. Equiserve is a free database containing information on the both types of programs at thousands of publicly traded companies across the United States.

The Importance Of Trading Psychology And Discipline

There are many characteristics and skills required by traders in order for them to be successful in the financial markets. The ability to understand the inner workings of a company, its fundamentals and the ability to determine the direction of the trend are a few of the key traits needed, but not one of these is as important as the ability to contain emotions and maintain discipline.

Trading Psychology

The psychological aspect of trading is extremely important, and the reason for that is fairly simple: A trader is often darting in and out of stocks on short notice, and is forced to make quick decisions. To accomplish this, they need a certain presence of mind. They also, by extension, need discipline, so that they stick with previously established trading plans and know when to book profits and losses. Emotions simply can't get in the way. 

Understanding Fear

When a trader's screen is pulsating red (a sign that stocks are down) and bad news comes about a certain stock or the general market, it's not uncommon for the trader to get scared. When this happens, they may overreact and feel compelled to liquidate their holdings and go to cash or to refrain from taking any risks. Now, if they do that they may avoid certain losses - but they also will miss out on the gains.

Traders need to understand what fear is - simply a natural reaction to what they perceive as a threat (in this case perhaps to their profit or money-making potential). Quantifying the fear might help. Or that they may be able to better deal with fear by pondering what they are afraid of, and why they are afraid of it. 

Also, by pondering this issue ahead of time and knowing how they may instinctively react to or perceive certain things, a trader can hope to isolate and identify those feelings during a trading session, and then try to focus on moving past the emotion. Of course this may not be easy, and may take practice, but it's necessary to the health of an investor's portfolio. 

Greed Is Your Worst Enemy

There's an old saying on Wall Street that "pigs get slaughtered." This greed in investors causes them to hang on to winning positions too long, trying to get every last tick. This trait can be devastating to returns because the trader is always running the risk of getting whipsawed or blown out of a position.

Greed is not easy to overcome. That's because within many of us there seems to be an instinct to always try to do better, to try to get just a little more. A trader should recognize this instinct if it is present, and develop trade plans based upon rational business decisions, not on what amounts to an emotional whim or potentially harmful instinct. 

The Importance of Trading Rules

To get their heads in the right place before they feel the emotional or psychological crunch, investors can look at creating trading rules ahead of time. Traders can establish limits where they lay out guidelines based on their risk-reward relationship for when they will exit a trade - regardless of emotions. For example, if a stock is trading at $10/share, the trader might choose to get out at $10.25, or at $9.75 to put a stop loss or stop limit in and bail. 

Of course, establishing price targets might not be the only rule. For example, the trader might say if certain news, such as specific positive or negative earnings or macroeconomic news, comes out, then he or she will buy (or sell) a security. Also, if it becomes apparent that a large buyer or seller enters the market, the trader might want to get out. 

Traders might also consider setting limits on the amount they win or lose in a day. In other words, if they reap an $X profit, they're done for the day, or if they lose $Y they fold up their tent and go home. This works for investors because sometimes it is better to just "go on take the money and run," like the old Steve Miller song suggests even when those two birds in the tree look better than the one in your hand. 

Creating a Trading Plan

Traders should try to learn about their area of interest as much as possible. For example, if the trader deals heavily and is interested in telecommunications stocks, it makes sense for him or her to become knowledgeable about that business. Similarly, if he or she trades heavily in energy stocks, it's fairly logical to want to become well versed in that arena.

To do this, start by formulating a plan to educate yourself. If possible, go to trading seminars and attend sell-side conferences. Also, it makes sense to plan out and devote as much time as possible to the research process. That means studying charts, speaking with management (if applicable), reading trade journals or doing other background work (such as macroeconomic analysis or industry analysis) so that when the trading session starts the trader is up to speed. A wealth of knowledge could help the trader overcome fear issues in itself, so it's a handy tool.

In addition, it's important that the trader consider experimenting with new things from time to time. For example, consider using options to mitigate risk, or set stop losses at a different place. One of the best ways a trader can learn is by experimenting - within reason. This experience may also help reduce emotional influences.

Finally, traders should periodically review and assess their performance. This means not only should they review their returns and their individual positions, but also how they prepared for a trading session, how up-to-date they are on the markets and how they're progressing in terms of ongoing education, among other things. This periodic assessment can help the trader correct mistakes, which may help enhance their overall returns. It may also help them to maintain the right mindset and help them to be psychologically prepared to do business. 

Bottom Line

It's often important for a trader to be able to read a chart and have the right technology so that their trades get executed, but there is often a psychological component to trading that shouldn't be overlooked. Setting trading rules, building a trading plan, doing research and getting experience are all simple steps that can help a trader overcome these little mind matters.