Today, I take a more abstract and deeper look at the issue of “why most traders lose money.” As you are reading, and as I point out in the article, individuals can escape from herding behavior and create above average (or below average) returns. That said, in order to break from the herd there are a lot of things that must be known about yourself, human tendencies and how these combine to form societal movements (which the stock market reflects). This article will show that what you believe may be your own path may be the exact thing which is keeping you a part of the herd, and thus always entering and exiting the market at the wrong time. It’s a fairly long article, it may piss some people off, but in long run accepting and learning to deal with the issues which are addressed in this article may help you to move into the small realm of successful traders.
Why Most Traders Lose Money and Why the Market Requires It
By: Cory Mitchell, CMT
Most traders have heard the statistics…”95% of traders lose money,” “Only 5% of traders can make a living at it,” or “Only 1% of traders really make money.” Whatever the particular number is from recent studies, the fact is, many traders will lose money and it simply cannot be avoided (for some hard numbers, see The Day Trading Success Rate, The Thorough Answer). All sorts of reasons are given for it, such as money management mishaps, bad timing, bad government policy, poor regulation or a poor strategy. These are all well and good…and some of those do definitely play a role in individual trading success…but there is a deeper reason. A deeper reason as to why most traders will lose regardless of what methods they employ. I purport, that even if all traders knew how (keep in mind knowing, and doing are two very different things) to trade successfully based on current conditions, still most traders would lose over the long run.
Why Most Traders Lose Money – The Market is Not Independent of Us, It Is Us
Why most traders lose money and what traders often fail to realize is that the market is the collective movement of their actions and reactions to their own actions and to other people’s actions. Sound confusing. Consider this: You tee up a trade, close your eyes and hit “enter” (open the trade). You have no idea what the market is doing (your eyes are still closed), but you begin to react to your action–you wonder if you made the right decision, if you should adjust your stop loss or if you should have gotten in earlier or later. That continues to occur after you open your eyes and see how your action (trade) is acting in relation to others people’s actions and reactions. Even seasoned traders can go through these emotions at times.
In other words, the market is a giant feedback loop, showing traders (and anyone who views the market) a thermometer reading of the social mood under which traders, and by extension society, are operating.
Most traders seem to think of the market is something that has some external value outside of the price attributed to it by traders. I prefer to think of it as a real-time gauge of a society’s view of their own productive capacity…or more simply put–social mood.
When markets are understood, the idea that everyone can make money is not only inaccurate but impossible and laughable. Everyone making money means there is no market, because who would be taking the other side of the trade?
In addition, most traders feel they can move with the crowd to make a (paper) profit, and then get out before the crowd, turning that trade into a real profit. In theory this is sound, but remember everyone else is setting out to do the same thing. It is this crowd movement which allows traders to make money at times. Without a large portion of traders coming to the same decision markets simply would not move. It takes conviction by many traders to create a trend, then it takes euphoric acceptance that “this is the new norm” to end it and “bend it. ” It then takes mass disillusionment to crash it the other way.
Why Most Traders Lose Money – Only Individuals Can Beat the Market, Not the Crowd (and the crowd is the 80-90+%)
Consider for a moment if every trader followed the rule of not risking more than 1% of their account per trade and used similar strategies toted by professionals. Stop loss orders would trigger all over the place and prices would inflate and deflate… just as they do now with people adhering to their own (and different types of) strategies! In other words, everyone trying to do the same “right” thing creates the same market movements as everyone doing their own “wrong” thing.
This is why most traders lose money and it is the paradox traders must overcome, for as Master Oogway proclaims in the movie Kung Fu Panda “One often meets his destiny on the road he takes to avoid it.”
Luckily, just as it is almost impossible to convince a bull to be a bear once he or she has taken a position, it would be even more unfathomable to convince each trader to trade a certain way. The point is, it doesn’t matter how people trade now, or if everyone traded the same…most would still lose. The attempt of the masses to avoid this (or to created profits) creates the very noose they end up hanging themselves with.
Why Most Traders Lose Money – Not Understanding the True Nature of Markets
With experience traders can learn to move with the crowd, and also realize the crowd’s fickle nature (and their own fickle nature as well). Traders may also finally learn that social mood dictates the markets and the news. This is directly opposed to the commonly held view that the news and the market dictate social mood (see: Does News Create Social Mood, Or Does Social Mood Create the News?)
Successful traders find something that works and stick to it, not letting others pull them away from their strategy. This is where most traders go wrong and why the crowd loses money. Despite most people’s best efforts they can’t pull themselves away from the crowd when it really counts.
When all your friends are buying stocks and talking about oil going $200 or $20 (or whatever the number of the day is) and analysts are all over TV saying it is so, it is hard to take a contrarian view. After all, if you make a bet against everyone else and you are wrong, your friends laugh at you because they’re thinking their paper profits which continue to expand are going to be cashable at the bank soon. You experience regret for missing out on making some money and also may feel some social sheepishness. And heaven forbid you are right and people hate you because you just made money while they lost their shirt. Sound ridiculous?
Consider the public uproar during the Occupy Wall Street protests, or people feeling great resentment for the hedge funds and traders that made billions by seeing the housing price collapse and taking advantage of it! Or the manager who is resented for getting to keep his job while several of his employees are laid off. Winning traders and correct analysts are often “crucified” during major market turns when the majority lose. (Remember markets are a reflection of society and a leading indicator of the economy, so when stocks are moving down the economy is teetering or already in decline and thus people are already “on edge” themselves).
It is very easy to say “I will follow the crowd and then know when to get out.” Actually doing it is something entirely different…which is why crowds move together. This could largely be due to the human tendency to Extrapolate Trends. Trend extrapolation is the tendency to project current conditions into the futures, often assuming all else will remain equal. (see Stock Market is Not Physics Part 1 for more on this).
And make no mistake, most hedge fund and mutual funds are no different, most take hits along with retail investors and traders, although usually not to the extreme of the uneducated trader who is more likely to completely wipe out his/her account when things go bad.
What is really interesting is that while a hedge fund may make an average of 20%/year over the last 20 years, the average investor in that fund has a high propensity to make far less than that. Why? Because they invest and pull out their funds at the wrong points, just as they do in the market (see brief video at the end of this article). The hedge fund or mutual fund is a (micro) market, where investors/traders can deposit and withdraw based on how they think the fund will do.
Side Note: Traders and investors must also be aware of “survivorship bias.” We are likely to hear more stories of people making a killing than hearing about people losing everything because the people who lost everything are gone from the public eye and are not talking about it. The few who make money are sure to let everyone know about it and thus create a sort of illusion–intentionally or unintentionally– that anyone can do what they did/do.
Also realize, everyone sets out to be an individual and trade their own way, and by doing so most end up being with the crowd that loses money (remember Master Oogway). Why? Because each person lets it happen..unwittingly. Their social mood, whether it be optimism, greed, fear, etc is likely being fueled by the same social mood prevalent in society. It is no mistake that individuals begin to like the same sorts of fashions that everyone is wearing. In a quest to change, the majority of society ends up changing together, moving towards similar desires and away from similar dislikes. Therefore, what the market is offering provides the exact thing that will lure the trader into the crowd.
For example, someone who has little experience investing in stocks wants to get involved because everyone else in their social circle is, ads are all over tv and even their nightly newscasters are talking a lot more about how the market is so good. In this environment you can be certain there will be lots of “helping hands” to welcome this investor to the crowd, teach them to be a part of the crowd and initiate them into the world of the blind leading the blind.
Why Most Traders Lose Money – Extremes Require Nearly Everyone to Get Onboard
While it may be starting to come clear, you may still wonder how it is possible most people lose money and how they seem to join the crowd at exactly the wrong time.
When a social mood, such as…oh, let’s call it “bullishness” takes hold of a society or a person, it can be very hard to see the movement for what it is–something that will pass! Everything passes (just like our moods oscillate)… just like the craze over tulip bulbs (See: Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay). So people buy and buy and buy, and then other people see this and buy and buy and buy.
Then there are the people who hold out, and say “No way, I am not doing that again. And anyway, I heard 80% of analysts are already bullish so it can’t go any higher.” But the market keeps ticking higher and so a few of the stragglers join in and buy. Some still hold out and the market keeps ticking higher. Finally, 85% of the population is bullish, and there are still some stragglers…and the market keeps going up. People are proclaiming their achievements and chanting that boom and bust cycles are a thing of the past. Finally, pretty much every person has become a bull, owning stock, and if they decided not to buy, they have given up (or been told to shut-up) on trying to warn others not to buy…and market plunges the other way.
The chart below shows this in a slightly different way. Since action is more important than talk, when fund managers have almost no cash on hand it means they are “all in” on the market and that means a reversal is likely to occur soon. The problem is that the market does not generally reverse lower until the funds/investors are all in, and it doesn’t move significantly higher until money has been pulled out of the market and most funds/investors are holding lots of cash to reinvest.
Source: Robert Prechter’s April 2010 issue of the Elliott Wave Theorist.
The market is unlikely to reverse to any significant degree until almost everyone is on one side. Which means almost everyone who joined that party late is going to lose. A bunch of people may just decide to wait, but so will the market. And if people are divided then the market will move in a ranging fashion.
People are the catalyst and without people to create an extreme the market won’t hit an extreme and reverse–remember the market does not act on its own, we…the people… are the market. In other words, the boom and bust cycles will not end. We progress and regress and then progress again.
Attempting to legislate the boom and bust cycles away is nothing more than political pandering, and is the result of the same mental processes which creates booms and busts in the first place. Again I refer back to Master Oogway’s comment in Kung Fu Panda “One often meets his destiny on the road he takes to avoid it.”
Political attempts to stop market crashes is nothing more than meeting our destiny on the road to avoid it, another problem is simply created or a bubble/crash occurs somewhere else. Markets are nothing more than the social mood of society’s participants expressing their view of their own and the collective productive worth. This can be further simplified by saying that my own productivity is largely determined by my overall mood. If I feel hopeless I don’t work as much or as hard, and I sell stock. If I feel good I work hard, play hard and buy stocks. This applies to almost everyone and while individual experiences vary, on a societal level it plays out in the same way.
Until almost everyone (who is watching that time frame, and has the ability and interest to trade it) is in the trend, it won’t stop. The trend will keep going, enticing more people in, and when it reaches critical mass (which it can’t do without pretty much everyone on board) a reversal occurs. This change in fortune (for the worse) causes concern and then panic as a full reversal occurs. And as the mood of society continues to grow darker people feel more hopeless and give up fanciful notions of making money with assets and so the assets continue to drop.
People then blame and pick fights with others because of their misfortune…blaming politicians and successful traders who have no more control over the situation than anyone else. This is a result of another human tendency to confuse cause and effect with events that simply happen in conjunction with each other (see the ‘devil gives you a wish’ example in the Stock Market is Not Physics Part III and also see the ‘Probabilities in Trading’ example in Probabilities: What are the odds Probabilities in Trading are calculated wrong? Part 1).
It was society’s own social mood which created the situation, and the social mood of the society which they (we) themselves were a part of, helped create and bought into.
The reversal then reaches a bearish extreme where people see no hope, but there are still shares out there and gold to buy and so a few start to buy and the whole process starts again creating waves of smaller and larger degrees across time.
Why Most Traders Lose Money – A Simple Numbers Game
Financial commentators will make statements such as “Most professional money managers can’t beat the S&P 500 benchmark….blah blah blah.” True. But it is not the professional money manager showing their ignorance, it is these critics who understand nothing about market movements.
Most market movement is created by professional money managers who are managing trillions of dollars in assets, and also by other professionals/businesses who need to transact or hedge risks to carry on their business. Therefore, if the market is up 10% in a year, it is because these professional fund managers have on average bought the market up 10%. Therefore, it is impossible for most professional money managers to make more than 10% that year, because it would be equivalent to asking someone to beat them self at a game of tennis.
Returns will be spread out from negative returns to triple digit returns, but on average they will have made about 10%, minus a management fee and expenses which means most fund managers will underperform. If the market is up 10%, the average hedge-fund return may be in the ballpark of 8 to 9% after fees, possibly lower.
The majority of investors and traders will not beat the benchmark because they themselves create and are a part of that benchmark!
Does this means the market adheres to the Efficient Market Hypothesis. Not at all. Certain traders do manage to outperform consistently. Also, recall the “survivorship bias” briefly mentioned earlier? Many traders and novice investors come to markets with a handful of bills and then lose it. There is a steady and continual stream of these people. They feed the kitties of those traders that are successful. Also, the very fact that so many people pile into (out of) market tops (bottoms) means there are favorable opportunities for those that can keep an objective eye on the market.
Since most traders trade on a shorter time frame than investors, consider this example. On day 1 the market is up 1% and on day 2 is down 1%. Most traders will be very near flat and then deduct fees and they are in the hole. Some traders will be up significantly, while others are down significantly. Which traders are profitable and which are losers may change from day to day over the next several months as similar up and down movements occur in the market. Consistent losers will drop off, contributing to the large number of traders who lose money. Traders who are profitable sometimes, but not very often, slowly move toward eventually sliding off the market grid as well.
Also consider this. In order for the glory stories to happen..such as traders making a 100%.. 500%…2000% returns (whether in one day, one year or several) how many traders must lose their shirt (or give up profits) for that to happen? Lots! Look at it a different way. That day trader that made $6,000,000 last year got that money from somewhere. Since small retail traders compose most of the total number of traders (high in number, small in worth compared to professionals) it was likely that $6,000,000 was taken right from those retail traders several thousand dollars at a time. Someone lost money (giving it to this successful trader) or gave up profits (allowing the successful trader to profit). For a day trader to make $6,000,000 in a year, that means about 120 people lost $50,000 each and/or gave up $50,000 each in potential profit!
That of course is not a direct relationship, there is more to it than that, but it does provide a perspective not often considered.
In other words, the very thing which lures people in droves to the markets (big returns) ironically means that most of those people will be on the losing end of that exchange. In another ironic twist, when people clamor into the market all at once out of greed and a belief that a new era has begun, they bring about the exact opposite.
As Individuals Apart From the Crowd
The crowd is not a crowd until most are involved.
Crowds can’t create strong trends until most are involved.
A trend won’t stop until nearly everyone is on board with the crowd.
When everyone is on board, it reverses.
Since it was likely the “big money” (that has to trade) that got the trend started and will likely be the first out, this small percentage of traders with the biggest pockets is likely to stay in the winners circle, even if that means making market average returns. The large number of small traders (a very high percentage of all traders) who jump on trends too late (or too early) and then tend to exit too late (or too early) will create the high percentage of traders who lose.
Therefore, most traders losing money is inevitable in financial markets. Only the few who understand this concept, who accept that what feels natural and good is likely the wrong choice, may manage to make money at this game. While this article provides a broad context, it applies to the small scale as well. Day traders get caught in the same crowd behavior without knowing it. That stock that won’t quit, which they watch all day before finally jumping in only to have it move the other way is the same phenomenon on a smaller scale.
Buyers and sellers can get exhausted, elated or sedate on any time frame. They experience short and/or long bursts of emotion which result in short and long-term actions/reactions, all leading to patterns which are visible on all time frames. There are are also degrees of bullishness and bearishness across time frames, meaning at times the runs and reversals will be aggressive and at other times more sedate depending on how many traders (and the public) are involved.
Also consider that if the a benchmark average is somewhere near what professionals are making on average –let’s say 15%/year–the average retail trader is attempting to make much more than this, and likely risking too much to do it. For people who want to make a living off trading it is hard to do so off making 15%/year on a $30,000 trading account. Therefore, retail investors are likely to over-trade and lose most of what they have–directly contributing to the 15%+ average return of consistently profitable hedge fund managers. For several hedge fund managers to make 15% on billions of dollars means A LOT of small traders will need to feed that kitty.
The only time the majority wins is when there is a shift in overall productive capacity of society, such as the impressive stock rally of the 80’s and 90’s––the latter part of which was more euphoria (bubble) . In my opinion, there were some major advances in technology during that time which could potentially do a lot of good, and thus the rise was warranted. Unfortunately, we have mostly squandered that potential good on primarily creating products and services which decrease productivity instead of increased it; products which provide us an escape from the real world as opposed to help us harness the real world. These major fundamental shifts do no occur often, which means that in the lulls between most traders and investors will lose money.
The bottom line is that traders must stick to a well-defined plan and trade that plan even when it is uncomfortable (and it often will be). The vast majority of the population, and thus the vast majority of traders, buckle under this uncomfortable pressure…the same way they reach for the chocolate bar instead of the carrots. Since most of the population is more than happy to join the crowd, by having some discipline combined with a decent strategy it is possible to be one of the few successful traders who actually can leave the crowd before it implodes on itself.
I welcome your reasoned comments, rebuttals or questions below, whether agree or disagree.
There is some great reading on how our biology seems to be wired for crowd behavior. Robert Prechter has compiled some of it in his book “The Wave Principle of Human Social Behavior and the New Science of Socionomics“.
As promised, here is that short video on how hedge fund investors usually get in and out at the wrong time, even when the hedge fund is successful. Video: Prechter on Hedge Funds and Herding Watch this surprising description of how hedge fund investors behave: