Rules for Small-Cap Investing

Rules for Small-Cap Investing: Repent Now! Avoid These 7 Deadly Sins
A Daily Reckoning Whitepaper Report
By James Boric — Editor, The Sleuth(Sign up for FREE!)

Be honest for a moment. Has something like this ever happened to you?

You are at a cocktail party or neighborhood barbeque. Your neighbor (the one you don’t like very much, but who thinks you are best buds) corners you between the hors d’oeuvres table and the horseshoe pit and starts talking about his recent good fortunes.

It turns out he made a windfall buying some startup biotech stock you’ve never heard of. A friend of a friend told him about the company and said it had a potential cure for breast cancer. It sounded legit, so he invested $10,000. Two months later he had enough money to pay for the brand-new BMW 5 Series sitting in the driveway across from your house.

The whole time your “bud” is telling you the story, you’re thinking, “How in the world can an idiot — whose claim to fame was when he lit his own hair on fire at the annual block party three years ago — make more money in the stock market than me? It makes no sense.”

Fueled by competition and envy, you immediately go home, log on to your computer and buy the same stock. Heck, if this moron can make a fortune, so can you. So you invest $10,000 too.

Rules for Small-Cap Investing:What Happens When You Don’t Follow the Rules

A month later, the company comes out with some breaking news. Its “sure-fire” cancer drug is no longer sure fire. Unexpectedly, it didn’t make it through the first phase of the FDA trials. To your horror, the stock immediately plunges and doesn’t stop until your $10,000 investment is worth a mere $500 (hardly enough to buy a scooter, let alone a new Beamer).

Sound at all familiar?

This is the scenario CFP John Wilkinson presented to 75 people at the Agora Financial Trader’s Conference in Puerto Vallarta, Mexico. He wanted to illustrate the routine mistakes traders and investors make that cost them a fortune — time and time again.

“The difference between professional traders and you,” John said on stage, “is that professional traders don’t fall victim to the seven deadly sins: greed, lust, envy, laziness, gluttony, pride and vengeance.”

The example of buying a stock in order to keep pace with your annoying neighbor is a classic case of envy. Sure, the story was a little over the top. But it happens all the time. And even if you haven’t fallen victim to the sin of envy, chances are you have violated at least one of the other six sins…

Rules for Small-Cap Investing: Deadly Trading Sin #1: Greed

This is where you desire more than you need. In the trading and investing world, greed rears its ugly head when you ignore price, asset allocation and position sizing. You buy too much of a “sure thing,” only to lose your shirt when you are wrong.

Remember, it is important to stay within your means any time you trade or invest. Never put more than 2-5% in a single position. Make sure you have a blend of stocks (small cap, large cap, emerging markets, growth, value) and bonds in your portfolio. The idea is to position yourself so you make money in all markets — and not get crushed if one thing doesn’t go your way.

Rules for Small-Cap Investing: Deadly Trading Sin #2: Lust

You hear about a stock that has such a sexy story you just have to own it. All of a sudden, things like fundamentals, balance sheets and cash flow statements don’t matter. You are drawn to the possibility of triple-digit gains. And nothing is going to stop you from investing.

It’s like Ralph Wanger told me last year in his Chicago high-rise…

How many guys go to the same chic bar every weekend looking to “get lucky”? Twenty hot shots scale the bar up and down looking for the hottest woman in the room. Then at the end of the night they all make their move — hoping to take the girl home. Problem is…

As they all make their move, they form a wall of drunk and sexually frustrated men around this one woman. Inevitably, she wants nothing to do with any of them and walks home — alone.

“Wouldn’t it be a lot better to look in the local library to find a woman?” Wanger asked me. “Most men don’t look there. It’s out of the way and not thought of as a sexy hangout. But a guy probably has a better shot of finding someone he could share his whole life with at the library than at a crowded bar with tons of competition.”

The same is true in investing, of course. The best opportunities aren’t the ones everyone is talking about already. The real money will be made by investing in the companies flying below Wall Street’s radar screen — the ones buried away in some library stack.

Rules for Small-Cap Investing: Deadly Trading Sin #3: Envy

This is when you hear a “success” story from a neighbor, family member or co-worker. They tell you about the fortune they made on stock XYZ. Feeling left out of the action, you buy the stock as well. You end up making an emotional decision to buy a stock. That’s almost never a good idea.

The true greats of Wall Street (Buffett, Templeton, Price, Greenblatt and Whitman) spend hours and hours each day understanding the business they are investing in. They make sure the company is fundamentally sound. They base their ideas on cold, hard facts…not emotion. And that’s exactly why they are billionaires and your neighbor isn’t.

Rules for Small-Cap Investing: Deadly Trading Sin #4: Laziness

You buy a stock without doing any due diligence of your own. Maybe you hear about a hot tip from a friend. You read an article in the newspaper about a sure-fire idea. Or you overhear your racquetball buddy talk about an opportunity with his broker. At the end of the day you think to yourself, “I am tired. I don’t have any time to do this research on my own. I trust my friend. So why not?”

Come on! This is your money! You work hard for it. So why not make sure you know how it is being invested? Read a company’s annual report. Look at its balance sheet. Look at some simple ratios. It will take you about two hours and will save you from investing in companies with no future whatsoever.

Rules for Small-Cap Investing: Deadly Trading Sin #5: Gluttony

You have unrealistic goals on a trade or investment. The average person (believe it or not) expects to make 400% in three months on a trade!

This is the sin that drives me the most crazy. Let me tell you right now: you will NOT make 400% in three months! Forget it! The greatest investors of all time make between 14-30% a year. So make sure your expectations are realistic.

Rules for Small-Cap Investing: Deadly Trading Sin #6: Pride

You make a decision to buy a stock and shortly after calling your broker, you realize your reason for making the trade was completely wrong. Instead of admitting your mistake and getting out for a small loss, you stay in the position. Inevitably, what happens? Your small loss turns into a very big one.

Rules for Small-Cap Investing: Deadly Trading Sin #7: Vengeance

After taking a loss on a position, you feel the need to blame someone. Whether it is your broker, your neighbor or your favorite small-cap editor, you spend a lot of time cursing someone else for your bad fortune — instead of learning and trying to understand what went wrong so you can improve moving forward.

At the end of the day, you have responsibility for your own portfolio. You should never invest in anything unless you are comfortable with the decision. Forget everyone else. Do what is right for you.

I recommend you print out this list of common investing mistakes. Read it every time you think about putting your hard-earned money into a stock. Make sure you aren’t falling victim to any of the seven sins. If you aren’t, chances are you will do just fine.

So go now and repent.


Editor, The Sleuth

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