To participate in the financial markets, both short-term traders and longer-term investors need to be comfortable about their holdings and their specific portfolios. In other words, if a certain position leaves you with a sense of uneasiness or the inability to sleep at night, it is not for you! Knowing the boundaries of your personal comfort zone makes it easier to maintain a portfolio that contains only suitable positions. So how do you find and establish these boundaries? Read on to find out.
Why Should I Be Comfortable?
Establishing a comfort zone is particularly important for a number of reasons:
- An uncomfortable trader or investor may allow emotions to take control of trading decisions.
- Those who are too complacent may ignore risk.
- Determining a comfort zone helps you avoid borderline trades that usually turn out poorly.
- It helps you recognize when risk has increased.
- It encourages you to take profits when very little profit potential remains.
- It minimizes the possibility that you'll be forced to make difficult decisions under pressure. Being comfortable with your positions means that high pressure situations should occur rarely.
Settling into Your Comfort Zone
Being in the "comfort zone" means owning a portfolio that contains only suitable, well-researched and understandable holdings.
Arriving at this type of portfolio involves going over your holdings yearly and deciding whether the reasons that you bought the stock still apply. For the stocks that don't make the cut, sell those positions, even if it results in a loss. Technically, the loss has already occurred and, except for tax reasons, turning it from a paper loss to one that is realized makes no difference. Once you've done this, you can put your money to work where you believe it will increase in value.
When choosing new stocks for you portfolio, remember that not every investment tip is a winner. In fact, it's best to ignore all tips and conduct your own research.
Long-Term Investor or Trader?
Despite the inconsistency of the markets, the vast majority of investors choose to adopt a long only approach by purchasing stocks, bonds, real estate, collectibles, etc. If you have good stock and investment selection skills, this method will do well over time. If you don't, and prefer to manage your own portfolio, different skills are required. For example, it may be worthwhile to learn how options work and how you can use them to hedge risk in stock portfolios.
At the same time, long-term investors must understand when a position is no longer suitable, either because it has run up in price very quickly, or the company is not expected to perform well in the future. You should work hard at mastering this skill - the time to recognize that some positions are too risky to hold is before disaster strikes.
The way you decide to invest in the market will determine your comfort zone. Day traders hold positions for a very short time. Swing traders hold longer, but by no means do they attempt to make long-term trades. And then there are the investors who have no specified holding period - and for many, that means they expect to hold for years. Which category you fall into will affect your comfort zone. For example, the day trader doesn't worry about sleeping well because positions are not held overnight, and the long-term investor is less concerned with timing. The one characteristic these trades should have in common is the suitability for the investor, who must find both the risk and reward potential of any position acceptable.
Becoming a full-time trader is a goal for many individual investors, who see it as a glamorous road to riches, but these perceptions are false. As with any other profession, it takes education, practice, skill and discipline to succeed. In the same way that not everyone can become a professional athlete or movie star, the simple truth is that not everyone can be a full-time trader. Keep this in mind when thinking about your comfort zone - if you don't succeed in making profits as a trader, you probably won't be very comfortable.
Trading Within a Comfort Zone
Both long-term investors and traders must make important decisions. Among the questions to consider are:
Is this a good entry point?
Is this an appropriate time to invest?
Is the security fairly priced?
How much profit do I expect to earn?
How much capital is at risk?
Is it possible this trade can result in a margin call?
What's the probability of earning a profit?
The Bottom Line
It's important to invest or trade so that you are comfortable with the nature of your holdings - and that's especially true when it comes to understanding both risk and reward. Once you find your comfort zone, staying within it will help you make better investment decisions. If a security doesn't fall within the parameters of your comfort zone, it's not a good investment for you.