Thursday, August 17, 2006

Why It's So Easy to Lose Money in the Markets

A reader recently emailed me a deceptively simple question: "Why is it so much easier to lose money in the markets than to make money?"

Well, let's look at a few reasons:

1) The stocks and indices most familiar to traders have provided the worst returns.

2) The time frame most comfortable for short-term traders (daytrading) has provided the worst returns.

3) The growth of stock index and ETFs has created automated arbitrage strategies that have greatly diminished market trending.

4) Markets tend to confound human nature by refusing to do in the next time period what they have done in the previous one.

5) Because of the above, following normal human sentiment makes people lose money in the markets, almost as if the game is rigged.

6) Because markets change their trending and volatility over time, we'll always tend to be most confident just as things are turning--and overconfidence is deadly.

7) There's no minor league for trading: once you place your order, you're up against the pros, who have a lot of tools at their disposal.

I've learned many things from traders, but this perhaps is most important: The most successful traders and trading organizations I've had the pleasure of getting to know are constantly adapting to changing market conditions. They don't rely on a single trading model; they are always modeling. They do not scalp the midday hours the same as they approach the early morning. They know the difference between a market with active institutional participation and one dominated by locals--and trade accordingly.

People are comfortable with the known, and that keeps them static. It is so easy to lose money in the markets, because markets are dynamic.


Ted said...

It seems like it would be harder to lose money than make money in the long run. But I think the reason people lose money more often is because of their propensity to sell after their investment's value goes down. The mean of the outcome distribution will be positive, but the median will be negative.

Ted said...

There are some funds with atrocious 10-year returns (like -33% annualized). It's very difficult to lose that much on purpose, unless you specifically target companies at risk of bankruptcy or trade enough that the cumulative costs become gargantuan.

Brett Steenbarger, Ph.D. said...

Hi Ted,

Thanks for your posts. I find that most traders utilize variations of momentum/trend based styles, which has subjected them to reversals in low volatility, non-trending markets dominated by arbitrage. Those large losses you cite are generally magnified by high leverage, esp. among hedge funds. But you're right: overtrading is a quick way to the poor house, given commissions, slippage, and the all-too-human tendency to be slower at taking losses than gains.


Mike said...

In trading I have often wondered whether doing exactly the opposite of what your trading instincts tell you would actually result in better results.

It needs some thinking through, perhaps some software that - hidden from view - did the exact opposite of the requested trading action. Sell for a buy order and so on.

After all if most traders lose money in the market it stands to reason that doing the opposite should be a winning strategy - or should it?

Brett Steenbarger, Ph.D. said...

Hi Mike,

I think you're on the right track. Some of the best trading system ideas I've seen have been set up to fade what the average trader would do in a situation. Of course, there is always the friction of trading to deal with--slippage and commission--so that just doing the opposite may not prove profitable. Still, as I noted in my recent Trading Markets article, some technical trading systems are only accurate 16% of the time. It seems like that's a decent edge (in reverse!) to start out with. Thanks--


muckdog said...

If I had only read the George Castanza "Make Millions Doing the Opposite" book about 15 years ago! Good list. It's just really hard to predict the future.

Brett Steenbarger, Ph.D. said...

You're so right, Muckdog! If I only would have bought the market every time I puked the lows in a misguided effort at risk management!! Emotionally retraining ourselves to look for those opposites is a major step of progress for developing traders, I find. Thanks for the note--


Chong Kong Hui said...

In short, who gain when most lose?