Amateur Hour - Five Mistakes Unsuccessful Traders Make

In my more than 20 years as a professional institutional trader, I have seen retail traders make many mistakes. Here are the five most common:

  1. Thinking that market moves are due to the what the news media is attributing them to

  2. Thinking that great traders have the so-called Holy Grail…some kind of infallible secret system

  3. Not thinking about and not having an understanding of risk management and investment psychology

  4. Thinking that what they buy is more important that knowing how to sell it

  5. Trying to catch the exact bottom or top

Number One - Retail traders think that market moves are due to the what the Financial News is attributing them to

In my not-so-humble opinion 99% of market moves have nothing to do with what the media is talking about or attributing them too. It is important to remember that the business model of most modern media is entertainment, not journalism. If you want to be a successful trader it is important that you learn to think for yourself.

The main thing that drives market moves are the underlying trends that are occurring and how markets react when they reach levels that are important. For example, suppose a market has traded down to a level that is important support and becomes very oversold. The odds are that it will bounce off of this level. The Fake News Financial Media will attribute this move to whatever the news story of the day is. If the markets sell off because they are overbought and reach important resistance the media will attribute this move to whatever the news story of that day is. In reality, the markets would have reacted in these ways regardless of what the news headlines were on that day. They are moving due to the supply and demand dynamics in the markets…not because of the headlines.

Markets also move due to ‘noise’. Consider the following situation. A client of a mutual fund wants to withdraw $100,000. The traders at the mutual fund need to sell a basket of stocks that is worth $100,000 to raise the cash for this withdrawal. On the same day, a different client deposits $200,000 into the same fund. The traders now need to invest these funds and literally buy a basket of the same stocks that they are selling. If they have time constraints, such as needing to complete the trades by the end of the day, then these stocks will rise in price. This move has nothing to do with whatever the media is attributing it to.

Dynamics such as these create noise in the market. Consider that this happens hundreds if not thousands of times a day at various firms across the world and you can understand how this will impact the markets.

I can assure you that there aren’t institutional traders who are watching the news and yelling ‘Buy!’ or ‘Sell’ based on news headlines. Two recent examples of Fake Financial News are the hysteria that surrounded Trade Wars and devaluation of the Turkish Lira. If you follow the markets you know that these have been two very popular news stories over the past few weeks.

The media was going into hysteria with news of the Trade Wars on July 6th. I did a quick Google search and found some notable headlines from that day:

Welcome to Your Trade War, World. It could get even uglier, so hang on tight - Bloomberg

How the ‘Biggest Trade War in Economic History’ Is Playing Out – New York Times

Trade War begins: US and China exchange $34 billion in tariffs – CNBC

'We are forced to retaliate,' China says after Trump's tariffs take effect – Chicago Tribune

China trade war hits agriculture harder starting July 6 – Feedstuffs

Fortunately, civilization did not collapse and just a month later we were faced with another economic calamity…the devaluation of the Turkish Lira. Here are some headlines from when this story hit the news on August 18th:

Turkish Lira 'Currency Crisis' Not Over, Could Hit 8 Against U.S. Dollar – Forbes

Could Turkey’s financial crisis have a snowball effect on world markets? – Washington Post

Stocks falter as lira wobbles – City Index

Currency market turmoil, trade tension to sway market during the week ahead – Economic Times

Turkey lira crisis: Six things you need to know – Al Jazerra

So…both of those stories sound pretty bad. People in the news media are experts on these matters so we should assume they know what they are talking about (not!). Take a look at this chart…it is the SPY (S&P 500) from May through September. I have left the dates off of it. Can you tell on which two days these calamitous events occurred? Surely this should be easy to do because according to the media the markets had some terrible news on those days so a reasonable person could conclude there must have been some massive selling,

Now take a look at this chart. I have these two important days identified. Clearly, Mr. Market disagreed with the Fake News that was being reported. As you can see, the market was in reality strong on these two ‘terrible’ days. This is a perfect example of how the media typically gets it wrong and why you should always be skeptical about the news that is being reported.

Number Two - Retail traders think that great institutional traders and hedge fund managers have the Holy Grail…an infallible secret method

As someone who has traded directly for two of the best money mangers in the history of the industry I can tell you unequivocally that this is not true. These systems just do not exist. There have been examples of methods that are exceptionally profitable but they have short lifespans because they invite competition. It usually surprises retail traders to find out that the best institutional traders are correct ‘only’ 58% of the time. What makes them successful is that they let the winners run and they are quick to close out of their losers. Successful traders understand that the real ‘Holy Grail’ to successful trading is risk management strategies and proper investment psychology.

Number Three - Retail traders don’t think about or understand risk management and investment psychology

Successful traders understand that people have not evolved in a way that is conducive for managing money. Entering a trade causes traders to be fearful of either taking a loss or missing out on a profit. This fear triggers an adrenaline rush and a ‘fight or flight’ response. This in turn causes traders to close out of their winners too soon and to hold onto their losers for too long. The reason why quantitative strategies are successful is because they don’t have emotions. Successful traders have an awareness and understanding of investment psychology. Successful traders understand risk and utilize risk management strategies.

Number Four - Retail traders think that what they buy is more important than knowing how to sell it

Successful traders have rules. They don’t trade off tips from their buddies, When successful traders enter positions they know where they are going to be stopped out and where they will take profits. You should not enter a trade unless you know where and how you will get out of it! This is the most important rule of successful trading. Not having an exit plan causes traders to succumb to their emotions and act illogically. Unsuccessful traders typically love to talk about the latest position they entered but they do not consider how they will get out of the position. They think that what they buy is more important than knowing how to get out of it. They are wrong.

Number Five - Retail traders try to catch the exact bottom or top

This desire to get the exact bottom or top is driven more by the emotional need to prove one is smart than it is by logic. If you do not have a plan, you are just guessing and will most probably get run over. Go to the casino instead…at least you can get free drinks. Successful traders have plans and rules that will define how they enter and exit trades. The don’t just guess that it is time to get in. It is not logical to enter trades without a definable reason.

Conclusion & Solution

If you are a retail trader that is looking to improve the most important thing to understand is that humans have not evolved in a way that is good for trading and to have an awareness of how this will affect your decision making. Trading triggers a ‘fight or flight’ response. Adrenaline may be a good thing if you are hunting Woolly Mammoths but it causes people to make errors when they are trading. If you have well-defined rules you will be far less likely to commit these errors.