There was a great article in the Sydney Morning Herald on trading and why most traders lose money. Regular readers know that I focus a lot of time and energy on understanding not only the psychology behind my own trading, but also the psychology of other traders. General Patton once said: “if everyone is thinking the same then someone isn’t thinking”. These words are never more applicable than they are to markets. After all, the name of the game, more often than not, is being in the trade before anyone else expects it. Markets rarely move where the majority of investors expect them to move. The article broke down the reasons for losing into 7 different common emotional mistakes:
1. Emotional bias: the tendency to believe the things that make you feel good and to disregard things that make you feel bad. In trading terms, this means ignoring the bad news and focusing on the good news. It’s called losing objectivity; you don’t recognise when things go wrong because you don’t want to.
This is the primary reason why most traders lose money. I believe it is mostly due to the fact that the majority of investors are generally biased in their thinking. They are trained to believe that buying stocks is the best way to invest in a market. They therefore ignore the other side of trades or other asset classes. This bias generally leads to a permabull perspective (or a permabear perspective for the more pessimistic). The general optimism of most traders (or pessimism) leads to cloudy thinking. Learning to be unbiased and flexible are perhaps the two most important rules to becoming a good trader. Trading one asset class with one directional bias would be like a professional baseball pitcher deciding to throw nothing but fastballs. You have many options and pitches – utilize them all.
2. Expectation bias: the tendency to believe in things that you expect. In financial terms this means not bothering to analyse, test, measure or doubt the conclusion you expect or hope for. It is also known as the law of small numbers – believing in something with little real evidence.
Focusing too much on the macro picture can often lead to this kind of skewed thinking. Peter Schiff is a great example. His macro inflationary theme is likely to be correct over the long-term, but in the near-term he has cost himself and his investors a great deal of money by not being more flexible and being able to adjust to the micro changes in the economy. I expect this current bear market to persist much longer, but that hasn’t stopped me from being bullish at times during the last 18 months. The market is a dynamic system and is constantly changing. Learn to evolve and change with it.
3. The disposition effect: the tendency to cut your profits and let your losses run – the opposite of what a trader should be doing. Making small profits and big losses is a recipe for disaster.
This is almost entirely due to a lack of discipline. All investors should have rules. Have price targets and set stops. Learn to be robotic in your investing style. If you give your emotions the opportunity to get in the way of your trading I can guarantee you they will. Hope is not a strategy when a trade doesn’t go the way you planned. One of the best parts about the stock market is that polygamy is perfectly acceptable. You aren’t married to any single position. Learn to “dump” the losers and move on to the next trade.
4. Loss aversion: the tendency to value the avoidance of loss more highly than the making of gain. Losses impact on you more than gains. Because of this you become more emotional when making losses, the point at which a rational decision would save you the most money.
The math behind stock market losses is unfortunate, but real. A 50% loss requires a staggering 100% gain to break even. This is one of the reasons why my focus is so keenly on risk management and money management. I have never experienced a draw-down of more than 15% in any given quarterly period because my risk management is superb. There are two kinds of volatility in the investment world: upside vol (good vol) and downside vol (bad vol). Finding investment managers with high Sortino ratios, i.e., very little bad vol, is very rare. The moral here is to learn asset allocation and the interconnectedness of non-correlated assets and you can in fact create portfolios that are structured to generate high risk adjusted returns while also being nearly invulnerable to black swans.
5. The sunk-cost fallacy: this is the tendency for our decision-making to be influenced by the size of the loss we have already incurred. The bigger the loss, the more likely we are to persist with a losing trade rather than take the rational decision to cut to a more profitable trade. The size of your loss has no impact on the future share price but a huge impact on your ability to make the right decision.
Position sizing is the most important form of risk management. If you invest your entire portfolio in a handful of high beta stocks you have to be willing to lose an extraordinary amount of money. Regular readers have likely noticed that I have a very patient “lie in the tall grass” investment style. I often wait for fat pitches, but never ever over allocate funds – even when I feel very certain about a trade. I always respect the fact that I can and will be wrong at times. Position sizing ensures that no single position can destroy years of hard work. Learning to allocate capital across a number of assets while creating a black swan proof portfolio is all about position sizing. Nassim Taleb wants you to believe that it’s impossible to avoid black swans (which is true), but black swans don’t have to be destructive as Taleb would have you believe.
6. The bandwagon effect: the tendency to think it must be right because everyone else is doing it – a thought process guaranteed to get you in when it’s obvious and get you out when it’s obvious. Put another way, it has you buying at the top and selling at the bottom.
As I said earlier, when everyone is thinking the same, someone isn’t thinking. Learn to go against the crowd. And when the boat feels like it’s tipping to one side, jump off or consider moving to the other side. And never let anyone tell you cash isn’t a position. If you feel uncertain or uncomfortable pull your portfolio out of the game. Like blackjack, there is no rule that says you have to play every hand. For more sophisticated investors cash can also serve as an alternative asset class via currency markets.
7. Past-price fixation: the tendency to avoid prudent trading decisions by anchoring your thought process to prices that no longer exist. “I’ll sell it if it gets back to $4.” “I’ll buy it if it gets down to $4 again.” We are all guilty. In trend-following trading, if the price goes up, you don’t sell it, you buy it; if it goes down, you don’t buy it, you sell it. The old high has gone, the old low has gone. Don’t wait for them to come back to do the wrong thing.
This goes back to being disciplined. You’re going to lose money. Deal with it. The real goal of trading is to make sure your losers don’t mortally wound your portfolio. Aim for singles and doubles and focus on not striking out. While home runs are exciting and the idea of finding the next Microsoft is grand and all the reality of it is that you’re highly unlikely to do either.
Good luck out there.
* Thanks to Emilia for the generous donation
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.