Why do most traders lose money?
1. If you observe most of the large cap stocks produce 15-20% annual returns on average. But the same stocks, on daily basis, move up or down easily to the tune of 1%.
2. There are 5 trading session per week. In an year, there will be 250 sessions approximately. (5 per week x 52 weeks = 260 less 10 general holidays = 250 trading days). If market is unidirectional, those stocks would produce 250% gain or losses. But markets go in both directions or remain sideways. Considering 20% gains a year on an average, which can come in 20 sessions, what the market does in rest of the 230 sessions? It plays ping-pong. Gains will be reversed and falls will also be reversed, resulting in no net gain. Take away is, for 230 sessions, probability of gains or losses is roughly equal.
3. If you are a day trader, going by simple arithmetic of 230 sessions erasing gains and losses of each other, every day you have an equal chance of winning or losing. But consecutive win probability reduces with the time. For example, first day it is 0.5, winning the next day too is 0.5 x 0.5 = 0.25. Probability of consecutive win for 5 days is, 0.5^5 = 3%. So your winning streak or luck does not last long.
4. Psychology impacts decision making skills and staying rational. If someone wins for few days, he becomes overconfident, increases his bets while his chances are winning again are reducing with each day. You know what will happen to him when his luck vanishes. Similarly, when someone loses consistently, he loses the confidence and reduces his stake. He does not know that probability of losing consistently is reducing with each lesson.
5. A trader can train oneself to play a bull or bear. Trying to be both is hard. Changing track is not an easy thing as one can interpret the signals wrongly and increases the losses.
What works for an investor?
All the disadvantages which the traders face are not shared by investor community as they largely ignore the daily volatility. Their focus is on the annual gains and not the short-term volatility. So they need not worry about law of probability of winning everyday. Yet they too can lose money, if they had picked a wrong stock or paid a wrong price.
One of the famous quotes from Warren Buffet is, “Rule 1: Do not lose the money. Rule 2: Don’t forget the Rule 1”
Well, how can an investor not lose money in the stock market? The stock you pick may go down the next moment you bought it. But there are many measures you can employ of setting the game in your favor.
1. Avoiding a wrong pick: You should learn about due diligence. You need to learn about business valuation. You should understand the underlying business, not just the stock. How does that company generates revenue? Who are their customers? What drives those customers to buy the products or services of the business you are evaluating? How long the revenue growth will last? How is their financial model? What are the margin structures of the business? Does that company generate sufficient cash to honor their payments, also invest into the future? Finally, the intention of promoters. Are they willing to share the profits with a common investor? Have they paid dividends in the past? Are they honest enough in their communication? Getting answers to all these questions is a lot of hard work and better you do that else you run risks of losing your hard-earned money. Proper due diligence is the only way out of a wrong pick.
2. Diversification: You do not invest all your eggs into a single basket for a reason. You want to live another day to fight back and not lose out if the only stock you hold runs into an unknown issue. Building a portfolio gives a balance. It reduces risks and also returns. Since our Rule 1 is to avoid losses, building a portfolio and avoiding concentration in just 1-2 stocks makes sense. As you build portfolio of 15-20 stocks, you need to make sure those stocks do not belong to the same industry or sector. Take a look at any mutual fund portfolio and observe how many stocks they hold, what is their Top 5 stocks concentration and also Top 3 sectors concentration. You will get a fair idea of how they structure a portfolio. You also want to have a fair mix of large cap, mid-cap and small cap stocks.
3. Avoiding wrong pricing: Once you have identified the stocks for your portfolio, you do not want to put all the money in one go. You will identify the fair price band for each stock and you will wait patiently for a discount before you invest into it. You do not want to enter at whatever price the stock is trading but buy at only discounts as per your estimate. Since you will put only a fraction of money in the market each time and continue that way over a period of 4-6 quarters to fully invest into a stock, it gives you good time to study that company and assess if your estimates were right or not and take necessary corrective actions.
With this knowledge, you can very well say now “When a trader makes money it is mostly luck at play, while an investor makes money it is mostly patience and hard work”. Many traders struggle to earn a living while many patient investors earn their fortunes in the stock market. Capital follows knowledge. Acquiring knowledge should become the primary aim of investor. Fortune will follow subsequently.
1. If you observe most of the large cap stocks produce 15-20% annual returns on average. But the same stocks, on daily basis, move up or down easily to the tune of 1%.
2. There are 5 trading session per week. In an year, there will be 250 sessions approximately. (5 per week x 52 weeks = 260 less 10 general holidays = 250 trading days). If market is unidirectional, those stocks would produce 250% gain or losses. But markets go in both directions or remain sideways. Considering 20% gains a year on an average, which can come in 20 sessions, what the market does in rest of the 230 sessions? It plays ping-pong. Gains will be reversed and falls will also be reversed, resulting in no net gain. Take away is, for 230 sessions, probability of gains or losses is roughly equal.
3. If you are a day trader, going by simple arithmetic of 230 sessions erasing gains and losses of each other, every day you have an equal chance of winning or losing. But consecutive win probability reduces with the time. For example, first day it is 0.5, winning the next day too is 0.5 x 0.5 = 0.25. Probability of consecutive win for 5 days is, 0.5^5 = 3%. So your winning streak or luck does not last long.
4. Psychology impacts decision making skills and staying rational. If someone wins for few days, he becomes overconfident, increases his bets while his chances are winning again are reducing with each day. You know what will happen to him when his luck vanishes. Similarly, when someone loses consistently, he loses the confidence and reduces his stake. He does not know that probability of losing consistently is reducing with each lesson.
5. A trader can train oneself to play a bull or bear. Trying to be both is hard. Changing track is not an easy thing as one can interpret the signals wrongly and increases the losses.
What works for an investor?
All the disadvantages which the traders face are not shared by investor community as they largely ignore the daily volatility. Their focus is on the annual gains and not the short-term volatility. So they need not worry about law of probability of winning everyday. Yet they too can lose money, if they had picked a wrong stock or paid a wrong price.
One of the famous quotes from Warren Buffet is, “Rule 1: Do not lose the money. Rule 2: Don’t forget the Rule 1”
Well, how can an investor not lose money in the stock market? The stock you pick may go down the next moment you bought it. But there are many measures you can employ of setting the game in your favor.
1. Avoiding a wrong pick: You should learn about due diligence. You need to learn about business valuation. You should understand the underlying business, not just the stock. How does that company generates revenue? Who are their customers? What drives those customers to buy the products or services of the business you are evaluating? How long the revenue growth will last? How is their financial model? What are the margin structures of the business? Does that company generate sufficient cash to honor their payments, also invest into the future? Finally, the intention of promoters. Are they willing to share the profits with a common investor? Have they paid dividends in the past? Are they honest enough in their communication? Getting answers to all these questions is a lot of hard work and better you do that else you run risks of losing your hard-earned money. Proper due diligence is the only way out of a wrong pick.
2. Diversification: You do not invest all your eggs into a single basket for a reason. You want to live another day to fight back and not lose out if the only stock you hold runs into an unknown issue. Building a portfolio gives a balance. It reduces risks and also returns. Since our Rule 1 is to avoid losses, building a portfolio and avoiding concentration in just 1-2 stocks makes sense. As you build portfolio of 15-20 stocks, you need to make sure those stocks do not belong to the same industry or sector. Take a look at any mutual fund portfolio and observe how many stocks they hold, what is their Top 5 stocks concentration and also Top 3 sectors concentration. You will get a fair idea of how they structure a portfolio. You also want to have a fair mix of large cap, mid-cap and small cap stocks.
3. Avoiding wrong pricing: Once you have identified the stocks for your portfolio, you do not want to put all the money in one go. You will identify the fair price band for each stock and you will wait patiently for a discount before you invest into it. You do not want to enter at whatever price the stock is trading but buy at only discounts as per your estimate. Since you will put only a fraction of money in the market each time and continue that way over a period of 4-6 quarters to fully invest into a stock, it gives you good time to study that company and assess if your estimates were right or not and take necessary corrective actions.
With this knowledge, you can very well say now “When a trader makes money it is mostly luck at play, while an investor makes money it is mostly patience and hard work”. Many traders struggle to earn a living while many patient investors earn their fortunes in the stock market. Capital follows knowledge. Acquiring knowledge should become the primary aim of investor. Fortune will follow subsequently.
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