Why Most Traders Fail – Part 2

posted on July 4th, 2011 by Bellmont Research Team

In part 1 of this article I discussed two separate issues as to why people attempting to trade the markets fail; the first was knowledge, the second psychology. I will now reveal the observations I have made over many years, which are really sub sections of these issues.

“When it comes to trading the markets there is a vast difference between knowledge and understanding”

I was once told by a wise person that investing without knowledge was gambling. At the time I tended to agree, but it wasn’t until I started investing that I really understood the essence of this message. What I have learnt over the years is that gaining knowledge was one thing, but gaining the right knowledge was critical. It has been my experience that when learning to trade the vast majority of information and education is of little use to most people, and hence why so many fail. More importantly, what I found is that once I had gained the knowledge I wanted to know whether I really understood what I had learnt. Let me explain…..

I can intellectually tell you about many things, such as how to fly a plane, but do I really understand how to fly a plane and would you be safe flying with me? The short answer is no. People read books and attend free or weekend seminars in an attempt to learn how to trade, however, in my experience all they really get is a little bit of knowledge and very little understanding. Let’s face it, would you really trust your money and financial future to a person who has attended a weekend workshop, bought some DVDs or read a few books?

The cold reality is that trading is one of the few things you can do where you know from the outset you will lose money. The issue I find is that whilst all traders agree with this statement on an intellectual level, the majority never believe it will happen to them. They say ignorance is bliss, but in trading ignorance can be very expensive, and in many cases more expensive than getting a good education.

It is common for those new to trading to trade markets that are high risk, to take on more leverage than they can handle and to get their information from all the wrong places. Ignorance leads to over confidence, especially if the person has been successful in other areas of their lives. Over confidence leads to over trading, trading short term and making poor decisions based on a perception that the trader is ‘bullet proof’. Many only find out all this when they lose their money.

The common theme amongst many traders who fail is that they falsely believe they can get rich quick by using very little money or time. This get rich quick idea is perpetuated by the many ‘would be’ share market educators and their free seminars or DVDs. Sadly, whilst this is a romantic idea it is a fallacy to think that a trader can be successful without a proper education, the right skills and experience. The market doesn’t care how much you think you know or that you might only have a few thousand dollars, it just does what it wants to do irrespective of whether you make money or not.

Learning to trade is a journey, and after having taught share trading for more than a decade I could literally write a whole book on the mistakes that traders make. Some of the most common mistakes I see include:

  • Failure to set stop losses or setting them too tight
  • Over trading
  • Over use of leverage
  • Poor money management
  • Relying on software to make decisions

Einstein once said that “Education is the progressive realisation of our ignorance”. In simple terms I believe this means that we don’t know what we don’t know. My experience is that the majority who trade the market do so with little knowledge, blissfully unaware of what they don’t know until it costs them a lot of money.

Whilst space does not permit me to fully explain the above common mistakes that traders make, what I will say is that the emotions of fear and greed rule all five of them. A major trap for traders is the tendency to act on emotions rather than logic. This means they don’t trust either themselves, their skills or trading plan, which stems from having a low level of knowledge, skill and experience. The end result is that the traders act through a fear of losing and end up taking a micro view of the market by watching their trades daily or even intra-day, worse still they make their decisions based on short term market volatility. This leads to the even bigger sin of ‘over trading’, as the trader chases the market in an attempt to regain lost capital or profit.

The fear of losing is amplified when there is little or no strategy in place and contrary to popular opinion, daily charts only show you the short term movements of the market as such I believe they are of limited value to the majority of traders. The use or over use of daily charts are a major reason why so many over trade, as many more short term triggers become evident, yet properly assessing the trend of the market is almost impossible on a daily chart and hence why so many fail.

I have often said that if you want to learn what the 10% of successful traders do, find out what the 90% do and don’t do it. You don’t have to be Einstein to figure out the majority of courses, books, software and websites out there espouse daily charts and trading daily or intra-day. They do so because it sounds sexy and therefore appeals to people’s greed or ‘get rich quick’ mentality. If it was as simple and easy as they make it sound then everyone would be a profitable trader. To be successful on the market I strongly suggest you don’t do what these pretend Gurus espouse.

The use or poor use of leverage leads unskilled traders to trade on emotion, set stop losses too tight and make emotional decisions. This is extremely evident in those attempting to trade CFDs, Currencies, Options and other leveraged instruments. Unless you can trade shares with cash, then in my opinion you should never attempt to trade a highly leveraged market like those I have just mentioned. Ignorance and overconfidence abounds in these areas as people often mistakenly believe that they can handle the fluctuating extremes that leverage brings. In these markets you could make or lose 100% in hours or minutes, and as such you need highly developed skills to handle this. For most, trading leveraged instruments is like giving the car keys to a 10 year old and telling them to play.

As mentioned in part one, successful share trading relies upon developing a simple plan and sticking to it. A trading plan must have your buy/sell rules, money management including stop losses, and how you intend to manage the trade. All too often I have asked inexperienced traders what their plan is and they either don’t have one or I get a very vague explanation.

Developing a good trading plan is critical to your success as a trader, and once it has been developed you need to rigorously test its effectiveness. Trading is not about finding a new indicator or tool that someone tells you will make you more successful, it is about having a simple plan and following the plan. I encourage everyone to learn more, but it is important to remember that if you change your trading plan you change its effectiveness, which may not be for the better. Therefore, each time you change a trading plan, you need to back test it. If you are not willing to back test your trading plan, you are gambling with your money and increase the probability that you will join the 90% of share traders that lose.

It may surprise you to learn that I do not trade using common lagging technical indicators such as MACD’s or moving averages. I find that relying on the latest techniques or computer software is of limited value and prefer to use the tried and tested techniques and strategies of masters such as Gann, Elliott and Dow to name a few. These techniques are leading indicators and as such they provide more consistent entry and exit signals than lagging indicators.

Using leading indicators means I am better placed to ‘time the market’, which ultimately results in more and consistent profits. I understand that it requires a little more work in learning how to apply and use some of these techniques, but you have to ask yourself do I want to trade the market successfully or not? If the answer is yes, then the effort is well worth it.

One of the biggest challenges facing traders is when to sell. Usually a trader will be armed with many theories on how to pick the best trades to enter the market, and in my experience they spend about 80% of their time trying to find these trades and very little time working out when to exit. When asked where they should exit these people often give a confusing array of examples that are, in most cases, more guess work than solid theory, or based on the fear of losing either profit or capital.

Traders dramatically increase their probability of success if they spend more time working on better managing their trades and where to exit. Trading for profit is about using sound money management rules and good exit strategies, in essence, following the golden rule of ‘let your profits run and cut losses short’.

When setting a stop loss it needs to be far enough away from your entry price to allow the trade to settle in, but close enough to protect capital. Everyone, regardless of whether you are trading or investing, needs to use a stop loss or have an exit strategy every time they trade. Failure to do so will result in taking unnecessary risks, less profits and larger losses. There are various stop losses you can use depending on what you are trading. For example, the stop loss I would use for a blue chip share is different to the one I would use for a speculative share or CFD. As a general rule of thumb, I always set my stop loss at 15 per cent below the purchase price when trading blue chip shares. Whilst I cannot go into stop losses in detail here, I have done many free podcasts that explain what I do in many areas of trading.

No matter what your goal is, it is essential to your longer term success as a trader to not follow the herd, or the 90% of traders who fail, but rather follow the rules and principles of the successful 10%. To this I will sign off, wish you every success with your trading and leave you with my top 10 tips, for traders and investors to profit from the share market.

  • Don’t dollar cost average
  • Don’t buy cheap small caps
  • Don’t buy and hold
  • Don’t over use leverage
  • Don’t be affected by the herd mentality
  • Use stop losses to protect capital
  • Buy only top quality stocks
  • Always manage your risk
  • Diversify but not too much
  • Lastly and most importantly – Educate Yourself!

Dale Gillham – Wealth Within

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