Active Trader: Time to Curb Your Enthusiasm

It’s not exactly advice you hear every day: Beware the rally.

But when the market goes on a tear, as it has over the past six months, it’s easy for investors to believe they have become trading geniuses. Indeed, all but a handful of the Standard & Poor’s 500 stocks are higher than they were in March. If an investor bought a stock and held it for any period of time, the stock is probably in the money.

But this is a dangerous time, experts say, because a trader’s inflated ego can get in the way of sound investing decisions. The thrill of buying a winning stock can keep them from selling that stock and locking in profits. “The human mentality is to want to have a winner,” says Todd Salamone, senior vice president of research for Schaeffer’s Investment Research. “It’s psychologically hard to admit you’re wrong.” Meanwhile volatility, after seemingly taking the summer off, has started to return to the stock market. The CBOE Volatility Index, known as the VIX and a commonly-used guage of the market’s volatility, was as low as 22 in mid-August, but popped up above 30 last week.

Many experts agree that investors have more success when they keep their emotions in check, which is just as hard to when the market is doing well as it is when the market is falling apart. The market has traded sideways for the past few days, so now might be the time to learn how to leave your ego at the trading door floor, when the odds of a trade blowing up in your face are low. Here are some tips:

Before you invest in a particular security, decide your time horizon and target profit — and the maximum amount you’re willing to lose. Decide how much volatility you’re willing to tolerate. Do-it-yourself brokerages like Fidelity and Charles Schwab allow customers to set stop-loss provisions that will automatically trigger the sale of a stock if its loss exceeds the level you program. If you expect to double your money within two years, consider setting a stop-loss provision that would sell if your investment loses 30%, Salamone says. (The most volatile stocks offer the most potential reward but come with the highest level of risk.) If you expect to increase your initial investment by 40% over two years, a realistic stop-loss could fall between 10% and 20% down, Salamone notes.

Fewer than half of your trades will work in your favor, many professional investors say. That doesn’t mean you can’t make money. The 875% that Apple (AAPL: 173.72, +1.56, +0.90%) returned over the past five years would have handily offset losses in other parts of a lucky investor’s portfolio. However, it does mean that you should only invest what you can easily afford to lose. It also means that you shouldn’t let any early gains go to your head. “It’s still really hard to beat the market,” says David Adler, the author of “Snap Judgment: When to Trust Your Instincts, When to Ignore Them, and How to Avoid Making Big Mistakes With Your Money.” Successful investors stick to their disciplined approaches no matter how euphoric — or despondent — they might feel.