Time to Graduate From Mutual Funds?
02/04/2011 3:45 pm EST
If you think you’re ready to mix it up with the pros, think again. The upsides are higher, and so are the downsides.
By Mark Chalon Smith
A few years ago, an unusually forthright day-trading site warned newly arrived investors that they would lose $10,000 before they learned enough to make any money.
If possible, that’s not pessimistic enough.
Making money is hard. Everything—even controlling your 401k—comes with a learning curve, and the steeper the curve, the more expensive the cost of the wrong decision.
Yet who hasn’t thought about taking charge? There is a small cadre of private investors who can live off their winnings, sometimes making more overnight than most people do in a year. They do not settle for 1.4% CD rates, or torture themselves by buying index funds that are never quite the right index fund. They use the same tools available to you, if you dared: options, futures, foreign exchange.
So, yes, it does sound sweet. And with online trading, disarmingly easy. But should you really do it? The simple answer: No way. It’s dangerous out there, and the markets feast on the uninitiated and overconfident. (Here’s an eye-opening look inside the world of options trading.)
There’s another answer as well: You could be one of the winners, if you invest the hours and hours of research needed to play the game confidently and consistently. It is the difference between riding in a plane and flying one.
It could take months before you have the necessary market IQ to crash and burn properly.
Then Why Bother?
“This part is simple: Nobody cares more about your money than you do,” says Joe “JJ” Kinahan, the chief derivatives strategist for TD Ameritrade, which owns the active trader site thinkorswim.com.
If all it took were caring, though, everyone who bought Pets.com would own a mansion rather than a sock puppet.
“To protect your money, you’d better be sharp and use the tools we and others provide,” Kinahan says. “You can trade stocks, you can use options, and you can make challenging choices. But you have to be aware of what you’re doing at all times.”|pagebreak|
If you’re not willing to make your finances a second job—or a first—then a financial adviser could be non-negotiable. Tax strategies, retirement dreams, and unexpected issues may call for special handling, even though you’ve got the investment calls covered. A planner could envision scenarios that you hadn’t thought of.
Liz Weston, a personal finance columnist for MSN Money, points to her own experience as instructional. Her original goal in learning about investing was to do everything on her own; but the more Weston studied, the more she realized the importance of professionals.
“I eventually knew I had to hire a team, including a tax consultant,” Weston says. “I understood how much others knew and could provide … and that I couldn’t manage everything 24/7.”
Financial advisers agree that most of us can handle basic investing, along the lines of choosing funds that reflect the major stock indexes or income-oriented bond or balanced funds.
But it’s unlikely they’ll hit the big payoff that can come from being right when a foreign currency moves your way or a momentum stock rises or plunges. And that takes time and expertise.
Consider Some Training Wheels
“There are lots of tools out there to help anyone make wise decisions if they want to go it on their own,” says Ross Levin, the president of Accredited Investors Inc., a financial planning firm based near Minneapolis. “But having an adviser, one who has experience and a consistent, well-articulated approach, can be invaluable. It can give one peace-of-mind.”
Albert Wallis sold his small pool contracting business in Southern California a few years ago. Since then he has managed his own portfolio, beginning modestly with mutual funds while he raised his stock buying aptitude through tools at two online brokers. Wallis had an adviser at the time but shifted more money into his online accounts as confidence grew.
He mostly utilizes a buy-and-hold strategy for stocks. But when he says “hold,” it’s usually for a set amount of time. When a stock seems to peak, Wallis sells. If a stock drops 10% below his buy point, it’s tossed. He’s taken the aggressive step of shorting equities when the market seems to turn against them.
“My record isn’t perfect, by any means, but I do pretty well and am ahead,” he says. “I enjoy the whole process, from visiting the company’s Web site for information and listening to analysts who cover the stock. I’m now studying options for my arsenal—I don’t know enough yet, but I’m getting there.”|pagebreak|
Ready? Now Ask Yourself …
–Do you really want the responsibility? If your first position lost money, would you be miserable or learn from the experience? Would you lose your cool if you made a few poor decisions?
Levin recalls a doctor who resisted becoming a client—until the bad moves stacked up. “A very smart man, but he was too reactive,” Levin says. “He traded 30 times a month, usually responding to news or other market events. It wasn’t working for him; he was making too many poor choices.”
These days, he lets Levin do much of the heavy lifting in determining which investments are best and how long to hold them. His account is growing and he feels more at ease. Steady hands are best for driving a portfolio, whether aggressive or tame.
–Idiot or savant? You think you understand the inner guts of the market, but do you really? You are about to gamble your hard-earned cash on it.
“The typical person is not willing to do what it takes when it comes to buying stocks,” Weston cautions. “Most likely you will make mistakes. That’s why I recommend keeping it really simple—I buy index funds.”
–Are you at ease with the online world? You’d better be. A full-service brokerage that executes your every whim will in the end eat your grubstake whole.
At the very least, you’ll need to navigate the Web adeptly to research individual stocks and to execute your trades. At the other end, some of the tools provided by online brokers for modeling investments and finding winners are excruciatingly detailed and demanding—yet those charts, technical analysis and screening tools may offer your best chance of making real money.|pagebreak|
5 Steps Before You Lose a Nickel
If you’re still determined, here are some first steps:
Research, study, learn. Rule of thumb: If you can’t explain a strategy to your neighbor, then you don’t really know it. Want to use options? Then you’d better understand them, in detail. If you can’t explain the difference between a put and a call, then find a good Web site, get a book or talk to an expert to learn. Also, look for investing seminars, in both the real and virtual world. Check with your broker if any are scheduled at a local branch or online.
Talk to professional traders. Many Web-based brokers with active trader components have members or employees eager to discuss their experiences. Call thinkorswim, for example, and ask for advice. They’ll hope you open an account, of course, but they should tell you what to expect, including the pitfalls.
Decide how much of your money is speculative. That’s a fancy way of asking what you can afford to lose without crippling the other plans in your life. Ten percent? 50%? All of it? Do you plan to stick with your own cash or get adventurous and use margin? Most sophisticated accounts automatically provide margin (increasing your buying power, usually two or four times), but you can get slaughtered if a trade goes south and you’re hit with a dreaded “margin call.”
Do it on paper first. Many proprietary platforms allow clients to practice with fake money and fake trades. Not ready to open an account? Then try it on your own: put trades on a spreadsheet and monitor their progress and your reactions to them. Did you make good decisions all down the line?
Go slow. If you do decide to go it alone, take it easy especially at the start.
Trade with, say, 25% of your stake and increase the amount as you become more comfortable. Buy companies you understand and are already familiar with.
“You don’t have to be fancy and jump on the hottest biotech stock,” Kinahan says. “I like to trade Walgreens because I know it. My wife shops there. … I understand how it makes money.”
Don’t get overconfident if you do well. You’ll have winners—and losers. Kinahan notes that the biggest mistake novice traders make is failing to plan an exit strategy, such as using stops to dump losing stocks or options to hedge losses. (See video: “A Good Exit Strategy Is Crucial.”)
At this level of investing, even losing money is a skill.
Mark Chalon Smith is a freelance writer based in Southern California. His writing has frequently appeared in both new and traditional media, including the Los Angeles Times.
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