This article appeared in the January 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Dale Gillham, Wealth Within
Anyone who starts down the road to becoming a trader eventually comes across the statistic that 90 per cent of traders do not make money. This statistic deems that over time 80 per cent lose, 10 per cent break even and 10 per cent make money consistently.
Over time does not mean a few weeks or even months, but years. All too often people who start to trade are no longer trading after two or three years, although they may have been profitable for a short period in that time.
An interesting point about the statistic is that it is not based on geographical region, age, gender or intelligence. Everyone aspires to be in the 10 per cent who consistently make money, but few are willing to put in the time and effort into achieving that.
When I give a presentation to would-be traders I ask if they want me to teach them what the 10 per cent of traders know, or the other 90 per cent, and every time they say the 10 per cent. To me, the answer to understanding the 10 per cent is simple - all you need to do is look at all the books and courses available and pretty much don't do most of it.
To be successful you need to do what the majority of traders don't. This may seem a simplistic view; after all, you don't know what you don't know, so how does an inexperienced person work out from the overwhelming load of information out there what they should be doing?
In this article I will explore why most traders fail and, more importantly, what to do to avoid being part of the 90 per cent statistic and also understand what the successful 10 per cent of traders do.
Three basic rules
Basically, to become successful trader the equation is really quite simple:
Knowledge + Experience + Hard work = Success.
No consistently profitable full-time trader has ever told me they got there through luck. All followed these simple rules and steps:
Step 1. They acquired the knowledge
Step 2. Once they had acquired the knowledge they developed their experience
Step 3. Those two steps are of no use unless the trader is willing to put in the hard work.
Another statistic is that learning to trade is a two-to-five-year experience. There is no substitute for hard work and there are no short cuts to becoming a professional and competent trader.
In reality, self-education requires both commitment and work. You don't have to be a genius or a rocket scientist to achieve consistently profitable returns in the sharemarket. In fact, I think it helps not to be a rocket scientist.
I have found that many newcomers to the market tend to complicate the process, and I attribute this to two things. First, the experts in the financial services industry often make investing in the sharemarket for the small investor seem complex, mysterious and only for those who are wise and highly educated.
Second, it is the marketing companies (read: many sharemarket educators) who promote that they have all the answers to gaining riches. They do this with statements such as "No knowledge, No experience and No time? No Problem, we will help you get rich quickly". In reality, all they do is fill their pockets from expensive seminars or DVD sets.
Lack of knowledge
This brings us to the single biggest reason most traders fail: a lack of knowledge. We can also put poor education into this area because many do seek education but look in the wrong places and therefore gain a poor education.
Many people I speak to refer to themselves as traders simply because they buy and sell shares. When questioned on how they analysed the shares they were buying and selling, many claimed they read reports in newspapers and on websites, and occasionally looked at online charts with their broker.
Further questioning reveals that although many had a rough idea of the fundamental information they needed to assess a share, they had little or no idea what they were looking at when it came to understanding how to interpret a chart. None had a plan or understood anything about money management.
An educated trader understands the importance of a trading plan, how to analyse a share to know why they are buying and selling, and how they will manage the trade. Most importantly, they also implement strong money management rules, such as stop-loss and position sizing, to ensure they minimise risk and maximise profits.
Recently I have seen traders and investors begin to place more emphasis on charting techniques in an attempt to make better-informed decisions about their investments, although in my experience this tends to compound the problem if they do not understand how to interpret a chart correctly.
Trading the sharemarket inherently involves some level of risk. Yet the majority of people attracted to the market are willing to take higher risks, believing they are adequately equipped to trade after reading a few books or attending a weekend course. Indeed, many traders seek instant gratification, plunging head-first into the market using complex strategies in the hope of profiting from their efforts. Sadly, many lose their hard-earned savings on unrealistic expectations.
We are told that knowledge is everything, but in the context of trading I believe it is the application of the correct knowledge that is everything. The streets are littered with would-be traders and in a bull market many are profitable mainly through sheer luck rather than good knowledge.
Strong bull markets tend to hide mistakes in judgement and lack of knowledge, which is why I say that unless you have been trading successfully for more than two years, you cannot consider yourself a trader.
Every week I am approached by people who want me to teach them to trade, and most want it to be quick, easy and cheap. If that sounds like you, then probability suggest that you are part of the 90 per cent.
Let's get real. Would you go to a "doctor" who has only watched some videos or attended a weekend workshop? Would you get your car serviced by someone who has done the same? Or allow your children to get on a bus if the driver has only read a book on how to drive?
Getting a university degree takes three or for year, or more, so you can get into your preferred profession. Similarly, trading is a business and those attempting to create that business need to treat the activity of trading like a profession. Failing to give trading this sort of respect is a major reason why most traders fail.
To be a full-time trader you need to combine a high level of knowledge with experience; otherwise, your probability of success over the longer term is very low.
The psychology factor
No matter why you trade, learning to trade is the easy part; the hard part is understanding your psychology - because it's true, the nine inches between your ears will determine your success as a trader.
If lack of knowledge is the main reason most traders fail, then psychology comes second. A trader's attitude or psychology determines not only how they approach the three basic steps mentioned, it also determines how they will approach their trading.
The emotions of fear and greed drive traders and investors alike, and without the correct education these emotions are often amplified, which leads to costly mistakes. To highlight this, we receive many calls from people with no knowledge or experience wanting to learn how to trade CFDs. When I ask why, they often say it is because they do not have much money. I suggest this is the exact reason why they should not be trading CFDs.
The thinking of people who tell me they have little money generally stems from greed. They believe that if they have $2000 to invest and the share they invest in rises by 20 per cent, then they will only make $400. Whereas if trading a CFD leveraged at ratio of 10 to 1 they will make $4000. Therefore, in their mind the desire for quick returns by trading a CFD is worth the risk, although in saying that they rarely, if ever, think about what they could lose.
Herein lies their challenge: if you do not have much money you tend to be more emotionally attached to it and as such cannot afford to lose it. Therefore, if the trade goes the wrong way even slightly, the fear of losing kicks in strongly, resulting in an exit and a loss.
Many novice CFD traders further compound their mistakes by exiting profitable trades too early for fear of losing their profit. This same story could be repeated for all leveraged trading, such as currencies, commodities and options.
Fear is the biggest enemy of a trader because it is a much stronger emotion than greed, and a trader's fear stems not only from a lack of knowledge or confidence in their trading plan, but also in the trader's confidence or belief in their ability to enact the plan successfully. The answer to solving this issue is to simply follow the three steps. Fear only kicks in once a trade is placed - what leads us to that point is greed or the desire for quick and easy returns.
The irony is that most people seek quick fixes to achieving their financial goals with the mindset that short-term gratification will fulfil their long-term needs. As mentioned, this is often spurred on by the proliferation of seminars and information available. What I discovered in my journey and one of the best strategies I apply today, is to keep things simple and to consistently revisit the basic foundations of trading.
I'll share some information you only get if you work in the industry. Recently I was talking to a couple of software/data providers, and over the years have regularly talked with brokers, CFD and other product providers. On mass, the overwhelming facts they report to me are that they have a large client churn or clients opening and closing accounts.
The majority of people who closed their accounts said they did so because they lost money - had become part of the 90 per cent. It is not uncommon to learn that the majority of those clients closed accounts in less than nine months. Would it surprise you that the majority are men?
It is a fact that many of you reading this article will not heed my words, believing you will not fall prey to the pitfalls I have mentioned - and yes, guys, this is mainly you. Why? Over-confidence or ego.
About the author
Dale Gillham, founder and chief analyst of Wealth Within, successfully trades tens of millions of dollars on behalf of clients using his proven and audited investment strategy. His company also specialises in delivering Australia's first and only nationally accredited Diploma and Advanced Diploma of Share Trading and Investment.
The ASX website has a wealth of free education material on charting. Visit the ASX Charting Library for stories that suit beginners through to advanced technical analysts. The ASX technical analysis course is especially useful for those who want to learn charting basics.
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