The Share Market

A Beginner's Guide

With the participation growth in the Australian share market, many Australians are taking their first step into the world of share investment and share trading. Although the share market is often painted as an essential part of everyone's long-term nest egg, the share market can be a roller coaster for the uninitiated. It is important to remember that the share market is the cutting edge of capitalism: greed and fear play an important role and everyone is aiming to make money.

When it comes to the share market, it always pays to listen attentively to Warren Buffet, arguably the most successful share market investor in the world. He suggests that to invest successfully over a lifetime does not require a stratospheric IQ, unusual business insight or inside information.

Over thirty years ago he wrote,

"What is needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework".

This is as true today as when he penned it.

Risk Management Plan: Limiting Loss

The adage about not putting all your eggs in one basket holds very true when investing in the stock market. firstly, Portfolio diversification is a basic tool to limit loss.

Secondly, the share investor/ share trader needs to detail the amount of loss they are prepared to accept for each stock purchased.

The table below clearly shows why cutting your losses early is an essential part of an investor or traders business plan.

Cut Your Losses

For the "sit and forget" investor, when it comes to badly falling stocks, it is important that the individual seek advice from industry accredited professionals and then act. Many individuals fail to act only to see their capital asset base shrink. As the share market is a serious business, the individual investor/trader needs to apply the same business concepts as would a business with a failing product. If a company's product line suddenly fails to sell, the product line is either changed or dropped in order for the business to survive. The same principle applies to the holder of a share that is in a downward spiral: the share needs to exited to save the wider portfolio from further capital loss.

Short-term Derivatives Trader

For the short-term derivatives traders (CFDs, Forex, Index Futures traders) a bearish market can be a happy playground as shorting is an equal part of every traders business plan. No matter the market conditions however, cutting ones losses is one of the biggest issues that every inexperienced trader faces. It is never easy to cut your losses because of the mindset that it may turn in your favour. Once a trader begins to live on the "hope" that the underlying instrument (share) will rebound or reverse in their favour, it can herald the beginning of the end. As Warren Buffet wrote, "keep emotions from corroding that framework". Set your own risk profile using the above table to see where you as a trader feel comfortable.

Diversification

The idea of diversification as part of risk management is clearly shown here: having all of ones investment in one share or one industry that experiences a major fall would severely diminish the long-term growth. This applies to short-term traders (including CFD, Forex and Index Futures traders) and investors alike.

For the trader, it has proven a costly mistake to enter similar trades within the same industry. For example, to have short-term "long" or 'short' trades on stocks in the same industry such as mining would exacerbate the risk. Imagine having BHP, RIO, AWC, or OZL all "long" only to see commodity prices fall overnight along with the $US and $A dollar swing against the trade. The stocks would all gap down, leaving the short-term trader severely exposed to substantial losses. For a leveraged short-term trader (CFD trader) the scenario would be even more dire.

Don't Over Trade

For most Australians, the idea is to invest in shares for the long-term and not to buy and sell too often. Mostly the investor will be rewarded for staying the course with a broadly diversified share portfolio, adding to the portfolio over time and exiting out of the 'dogs' as time goes along. For the short-term trader, as you trade more often there will obviously more exposure to a range of stocks. Subsequently you will come in contact with the "dog" more frequently. Don't get bitten.