0Why 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.
. 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.
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.
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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
