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. All sorts of reasons are given for it, such as money management mishaps, bad timing, 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.
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 as 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 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 that 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 touted 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 create 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 future, 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 the 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.