Newbie Do's & Don'ts

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Newbie Do read this article:

TraderMike: The Basics of Trading Part I
Psychological Aspects of Trading

I have recently been reading a study by Terrance Odean, an assistant professor at the University of California.

Odean received the trading history of over 60,000 accounts that where active been 1991 and 1996 from a discount broker and used the data to study the trading behaviors of online investors. Not surprisingly, most of them under performed the stock market and only a small minority beat the market. In fact only half of active traders managed to just break even. Most simply made little or lost a little. Only a small minority produced outstanding returns(the top 5% had an average return over 2.41% a month and only 1% had a return over 4.86% a month. Professional investors do not fare all that much better as half of all mutual funds fail to beat the S&P 500 index every year.

The failure rate of investors and traders is a different picture than that which is portrayed by online and traditional brokers through their advertisements. In fact if most people actually lose money in the stock market, then the market is more like a pyramid scheme in which wealth is simply transferred from the mass and given to the brokers, stock manipulators, market makers, and a small super trading elite at the top than the get rich fantasy that is so often presented. A view that some might find romantic would picture it as a pure Darwinian survival of the fittest and leave out the part about the manipulators. One would need more data to confirm if either of these views are true. A study on how many trading accounts are opened and closed would prove or disprove this. If brokers must continually recruit new accounts to replace ones closed due to losses than these two pictures of the market are correct. Money earned outside of the market is brought into it and given to professionals and manipulators. Just like a ponzi scheme, more money has to be recruited to keep the engine running. For a pyramid to continue new blocks must be placed on it. No matter how the market is structured, what is more interesting is trying to figure out why it is that many people lose money and a few make a lot of money in the stock market. What can we learn from that to increase our own returns?

How do most people lose money? Odean’s trading data shows that almost all individual investors generate poor returns by selling winning stocks too soon and holding on to losers. He argues that they do this because they are "overconfident." They consistently believe that their losers will come back and the market ends up proving them wrong. When they have a winner they sell them too soon, fearing that it will become another loser.

Odean’s study provides a great resource about the behaviors of active investors. However, any conclusions about motivations that can be drawn from the data are merely theoretical and cannot be proven. This isn’t his fault, its simply the nature of proof and evidence. There is no way one can extrapolate the motivations of thousands of individuals by studying number data and one doesn’t have the resources to ask all of these people about their motivations. One can only manufacture logical explanations from the data.

This isn’t a bad thing. You can learn a lot by thinking in that manner. My guess is that people do not lose money in the markets because they are stupid or because they aren’t pros. Remember that most mutual funds also underperform the stock market. I believe the primary difference between winners and losers is psychological. Winners and losers are presented with the same set of information, however the winners take different actions. What guides their actions? From my own history of losing and then making a lot of money in the stock market and study of general and trading psychology I’ll try to come up with some explanations. I believe that the actions of losing traders are guided by fantasy and a fear of losing while winning traders are guided by confidence. Without the proper mindset and attitude you cannot make money in the stock market. It’s not a guarantee to being successful, but it’s a prerequisite. However, the stock market is an environment that makes it difficult for most people to obtain this proper mindset, let alone maintain it.

environment -> senses -> beliefs -> identification -> motivation -> actions

The human mind gathers information about the outside world through the uses of it’s senses. It recognizes the information and then processes it. It then identifies it and responds to it with a whole host of beliefs, unconscious and subconscious. Based upon a person’s motivations and interpretations of what is taking place he carries out an action. The key is that actions that people take are based upon their own set of associations with what is going on in the world outside of them. These associations are based upon past experiences and a person’s beliefs about himself and the task at hand. The world consists of inputs that make people feel and they respond.

To relate this to trading, winning traders and losing traders experience the trading environment differently. It makes them feel different and as a result their actions consistently vary. In pyschological terms, they interpret the market differently because they have a separate belief system in the way that they see themselves relative to the stock market.

Let’s list these beliefs and actions below:

Belief statements that different traders can make:

Winning Traders

The markets provide an opportunity

The markets exist to give me profits

If I get stopped out then I have to reevaluate the trade

If the market doesn’t do what I expect then I must reconsider

I’ll take one trade at a time.

I don’t have to be perfect, I just have to do my best.

Money is not that important

Losing is part of the process of making money

Trading is a game, I know I can win

Every setback provides me with new market information

I can wait for an opportunity to come



Losing Traders

I must be in the market now

If I lose on this trade I am a loser

If I wait for my trading rules I’ll miss out

If I get stopped out I have bad luck

I can’t lose money

The market makers got me again

I’m an idiot, how could I lose money

What will they think when I tell them I lost money on this one?

The stock market is rigged

It’s impossible to get a good fill

I cannot take a loss

If I take my profit then I am right

These different beliefs create different characteristics of winning and losing traders:

Winners:

Get pleasure from trading the market as an end in itself

Not motivated primarily by money

Confident that they can make money in the market

Not afraid to take a loss

Patient - waits for opportunities

Uses a highly planned strategy

Is well prepared, done his homework

Measures the risk/reward ratio of every trade



Losing Traders:

Never define a loss

Locked into a narrow belief system

Hesitate to make a trade

Do not stick to a system

Trade by whim

Trade by emotion

Have no consistent strategy

Do not practice risk management

more interested in proving themselves right then being a success



Financial markets are structured in such a way that make it very difficult for someone to approach them with a confident psyche; and that is why it is so difficult for most people to make money trading them. Almost all environments - the workplace, family, friends - provide external forces that limit a person’s behavior. They provide a set of rules of what is right and wrong and what actions are to be rewarded or punished. This is not true for the stock market.

The stock market does not care if you make or lose money. The market has no control over you. Since the market does not exert any external control over your actions you have to fashion your own system of rules and have the discipline to obey them in order to be successful. No one else will do it for you. You have to have the confidence to take this responsibility yourself. It takes enormous self control and discipline.

Most people cannot take this approach. Instead they construct a fantasy in which the market provides them with future riches. They transplant these fantasies on to the individual stocks that they purchase and have difficulty confronting the reality of being wrong. When events don’t match their illusions they simply ignore them. If a stock they bought drops below their purchase price they refuse to reject the fantasy that their decision to purchase the stock will make them money and instead convince themselves that it is a winner that merely isn’t in favor yet.

However, stocks do not make successful traders money. They do it themselves. Instead of believing in the power of stocks, they believe in the viability of their own trading strategy. They have faith that their own disciplined interaction with the stock market will make them money and not the other way around. The decision making freedom the stock market gives ruins most active investors, but handsomely rewards the few prudent traders.

As I said earlier it takes extreme confidence to execute a well planned trading strategy and most people cannot find it. Instead, they often experience intense anxiety in the market. They may come to believe that the markets are rigged against them. The market doesn’t cause this. It’s their lack of strategy that twists them into emotional knots.

What one has to do to move from a fear stricken psyche to one capable of building enough confidence to make money in the market is to first believe in oneself and develop a strategy that consists of strict money management techniques. I’ll discuss how I have done this later. But, once you have a strategy in place you have to have the fortitude to continue to believe in it when you suffer losing trades. Losses are a part of the game. The way to make money is to accept them and to use money management techniques to keep your winners larger than your losers.

You have to move away from a mindset that stocks will make you rich and believe that your trading method will make you money. Then you must come to realize and hold the belief that being right or wrong on each individual trade does not matter. You have to be able to move through the adversity of losing trades and hold the faith that you will make money in the long run. This is why people find it so difficult. People focus too much on the individual trades and hold unrealistic fantasies about them, while they cannot take responsibility for the decisions that go wrong. The worst ones take it personally. Most never understand what is required to succeed.

The bad news in all of this is that if you are trying to generate large percentage returns on your account the odds are stacked against you. The odds of someone starting small and making a lot of money in the stock market are probably the equivalent of a rookie league baseball player making it into the big leagues. The good news is that most people trade recklessly, on pure emotions, and with little or no strategy so the competition isn’t so hot. Dedication and following a sound strategy can go a long way. I try to demonstrate that and encourage you in that direction with this newsletter and website.



To read the Odean studies yourself click this link:

http://www.gsm.ucdavis.edu/~odean/papers/returns/returns.html