(Copyright (c) 2000, Dow Jones & Company, Inc.)
If we were good boys and girls, we would save regularly, build diversified portfolios, trade little and keep a close eye on investment costs.
But unfortunately, most of us aren't good. Lurking inside every long-term investor is a day trader itching to get out. Partly it's human nature. Partly it's the long bull market. Emboldened by years of impressive investment gains, we are feeling pretty cocky.
What to do? If you are going to gamble, the trick is to make sure you don't do too much damage. Here's how:
Tie Your Hands. Resolve to trade with only 3%, or at most 5%, of your total portfolio, and then stick to this limit. You shouldn't be dipping into other parts of your portfolio to fund your speculation. Indeed, you may want to establish a fun-money account at a different brokerage firm from where you usually do business, so that you are not tempted to raid your other assets.
Kiss It Goodbye. "When you set up your speculative account, you should assume that this is lost money," says Hersh Shefrin, a finance professor at Santa Clara University. "Psychologically, get the reference point down to zero. If you have great hopes for your speculative account and you are very loss-averse, it can be a lethal combination because, if you lose, you'll dip into the money you set aside for other goals in an attempt to get even."
Trade in Your IRA. This may sound like heresy. After all, individual retirement accounts are supposed to fund retirement, possibly your most important financial goal. But the reality is, life will be a lot simpler if you trade in your retirement account, because you won't have to list all your gains and losses on each year's tax return.
Still, there is one drawback. If you turn out to be a really rotten trader, you can't take tax losses in your retirement account, like you can in a taxable account. These tax losses can be used to offset capital gains and even ordinary income.
Go for the Slow Death. Like the gambler in Vegas, you want to make sure your grubstake provides an entire evening's entertainment. To that end, avoid investments where you are likely to lose everything.
In particular, steer clear of options and futures. Also, avoid selling stocks short, in a bet that their price will fall, and borrowing money to buy shares on margin. In fact, if you are trading in a retirement account, you will find many of these strategies aren't allowed, either because of government regulations or your brokerage firm's own rules.
So what should you do? Stick with no-load stock funds and well-capitalized individual stocks, and pay close attention to investment costs. "Costs matter," says Minneapolis financial planner Ross Levin, who advises buying and selling through a discount-brokerage firm. "You don't want to go to a full-service broker to do this trading."
Let Your Winners Run. As you pursue good short-term performance, keep momentum on your side, by hanging onto winning investments, while dumping your losers quickly. Academic research suggests that the best-performing stocks and funds in any given year often enjoy good results in the year that follows. Meanwhile, losing positions tend to keep on losing.
"People want to stick with something that's down," says James O'Shaughnessy, chairman of O'Shaughnessy Capital Management in Greenwich, Conn. "Don't do it. Let the momentum work for you. If you've got five stocks and two are winning, sell the other three and concentrate your money on the ones that are winning. And the minute you see a break in the momentum, get out."
This is also the smartest tax strategy, should you decide to trade in your taxable account. By hanging onto winners, you delay the capital-gains tax bill, while selling losers generates a loss that can be used to reduce your taxes.
Keep Score. With your fun-money account, possibly the biggest danger is making a lot of money. That will boost your self-confidence and thus encourage you to trade even more.
Some folks, no doubt, will be successful. If you have a bunch of people making risky bets, at least some of them will enjoy blowout gains. Most investors, however, will wind up as losers, as their portfolios are pummeled by a combination of soured bets and hefty investment costs.
But even these folks may have a rosy recollection of their performance, as they remember their winners and conveniently forget their losers. "Everybody wants to talk about the big fish they caught," Mr. O'Shaughnessy says. "They don't want to talk about the 10 that got away."
To keep yourself honest, track your performance. The easiest way to do this is to seed your fun-money account with, say, $5,000. Thereafter, don't add or withdraw any money. To figure out how much you have gained or lost, simply check your account balance -- and try not to wince.