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Trading is a different discipline from early-stage investing. However, many angel investors and venture capitalists engage in the former to access growth potential in different investment spheres. Some people can be very successful in trading, but it is not easy or common.
Investor biases can inhibit decision-making, and imperfect information can obscure the true picture of a stock. Below, we identify six common trading pitfalls and ideas to mitigate them.
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#1 Not researching an asset properly
Even experienced investors can be tempted by a popular or “hot” stock, rushing into an investment before researching it thoroughly. However, a lack of due diligence can heighten the risk of losses later.
Adopting a thorough and consistent due diligence process can help investors restrain themselves from “herd mentality”. Check the underlying fundamentals carefully – e.g. income statements, balance sheets and annual reports.
Be careful not just to follow one source of news about the firm. Rather, collect information from a wide range of sources. Examine contrarian opinions and weigh them up against the “consensus view”. Regularly ask yourself: “Am I missing something?”, before investing.
#2 Not understanding leverage
Should you take out a loan to open a position? Many investors would (rightly) say no, or veer away from this. However, this is essentially what an investor does (often without realising) when they decide to use leverage.
Leverage can be attractive because it offers the chance to amplify gains. However, it can also exacerbate your losses. Inexperienced investors have been known to completely wipe out the value of their account using leverage.
Be careful to examine your investment objectives, experience level and risk appetite before using leverage. As a general rule, it is usually best to avoid it. Better to trade with the money you own, rather than money you do not own.
#3 Overdiversification
Investors are typically vulnerable to the “loss aversion” bias – i.e. they fear losses more than they enjoy winning. This can lead to irrational decision-making, such as panic-selling when a stock temporarily falls. It can also cause an investor to overdiversify.
Overdiversification occurs when your money is spread across too many investments. Whilst this can dampen the short-term volatility in your portfolio, it can also dampen your returns. If one stock performs well, the overall growth impact is minimal.
Here, investors can seek professional financial advice to discern an appropriate diversification strategy for their own unique goals, risk tolerance, current position and time horizon.
#4 Lack of diversification
On the other side of the coin, many investors fall foul of the opposite danger – concentrating their account in too few holdings. This can lead to overexposure to the risks associated with a single asset type, market or investment.
For instance, holding all of your trading account in a single cryptocurrency would expose you to diversification risk. If that asset suddenly plummets (cryptocurrencies are notoriously volatile), then your portfolio is likely to suffer far more than a well-balanced one.
Again, consider speaking with a financial adviser to ensure you avoid putting too much capital into a single industry, cryptocurrency or asset type (e.g. property). Diversification helps to mitigate their individual drawbacks whilst granting you greater access to their strengths.
#5 Too much reliance on software
There are some very clever trading platforms available in 2024 that allow investors to automate many activities (e.g. buy/sell orders). Artificial intelligence (AI) has advanced these solutions even further since 2020, empowering investors to identify patterns and trends in the market using algorithms and machine learning techniques.
However, software solutions will always lack the human judgement (e.g. “gut feeling”) that so often comes in handy across different spheres of life. Although human error is always a threat, human judgement allows investors to be proactive – not merely algorithmically reactive.
If you want to use trading software, consider using sound manual processes – e.g. backtesting automations – to “future proof” the system before it runs in live markets. Have an alert system ready, in case you need to jump in should things go wrong.
#6 Not understanding risk-reward
How much risk are you prepared to take to access a potential investment reward? Many investors do not know their risk appetite. Or, they are not honest with themselves about it. However, a lack of self-knowledge in this area can lead to costly mistakes in your portfolio.
Before taking a position, consider the risk-reward ratio. For instance, if you set a stop-loss at £100 for a stock, and a sell order at £100, then the risk-reward ratio is 1:1.
However, if the latter is actually £400, then the ratio is 1:4. This means you have a 40% chance of being right and collecting a profit.
Different investors will be comfortable with different risk-reward rations, depending on their experience and other factors (e.g. investment horizon). Whatever your attitude to risk, many sure you have a risk management strategy in place. This will give you a strong “mooring” for basing investment decisions if markets become volatile.
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