It is a well known fact that most investors lose money in the stock market. The numbers vary from 80% to 95%, but the fact remains. There are many reasons why people lose in the stock market. But the main reason is related to human emotions.

 · Role of Psychology in trading

Dr. Van Tharp is known for breaking down the trading process into three categories that affect traders. He categorizes them by importance as follows:

 
• Trading strategy (10%)
• Money management (30%)
• Psychology (60%)
 

According to Dr. Tharp, the psychological outlook and an individual’s way of thinking towards trading is the most important factor for success. The fact that the actual trading strategy is ranked the least important by Dr. Tharp, suggests that regardless of how successful a strategy is, psychology is the key to being successful.
 

This article from IAG Wealth Management explains things very clearly.
 

Recent study by DALBAR shows that investors consistently underperform the broad markets by significant margins. For the 30 years ending 12/31/2013 the S&P 500 Index averaged 11.11% a year. A pretty attractive historical return. The average equity fund investor earned a market return of only 3.69%.

To put this in perspective, if you invested $100,000 in 1984 in the S&P 500 and earned 11.11%, today (30 years later) you would have $2,358,275. If you started with $100,000 and invested it over the same time period at 3.69%, you would have $296,556. That is a difference of $2,061,719. It should be clear from these numbers that individual investors have a problem.

 · Why Investors underperform the markets?

Fidelity Investments conducted a study on their Magellan fund from 1977-1990, during Peter Lynch’s tenure. His average annual return during this period was 29%. This is a remarkable return over the 13 year period. Given all that, you would expect that the investors in his fund made substantial returns over that period. However, what Fidelity Investments found in their study was shocking. The average investor in the fund actually lost money.
 

The main reasons for the poor performance of individual investors are:
 

• Human Psychology: Individuals make decisions everyday with their emotions assisting their judgment.
 
• Performance chasing: Investors who chase performance are highly likely to lose money over the long term.
 
• Casino Investing: Many people think they can make money by winning the lottery.
 
• The “me too” lemming investment strategy: This is a common strategy of people who don’t know what they are doing with their investments.
 
• Fear and Greed Investing: Those are the most powerful motivations for investors. Unfortunately, investors tend to alternate between these potentially destructive emotions.
 
• Traders sell winners at a 50% higher rate than losers. 60% of sales are winners, while 40% of sales are losers.
 
• Day traders with strong past performance go on to earn strong returns in the future. Though only about 1% of all day traders are able to predictably profit net of fees.
 
• Traders with up to a 10 years negative track record continue to trade. This suggests that day traders even continue to trade when they receive a negative signal regarding their ability.
 
• Profitable day traders make up a small proportion of all traders – 1.6% in the average year.
 
• Among all traders, profitable traders increase their trading more than unprofitable day traders.
 
• Investors tend to sell winning investments while holding on to their losing investments.
 
• Investors are more likely to repurchase a stock that they previously sold for a profit than one previously sold for a loss.
 
• Individual investors trade more actively when their most recent trades were successful.
 
• Traders don’t learn about trading. “Trading to learn” is no more rational or profitable than playing roulette to learn for the individual investor.
 
• Investors overweight stocks in the industry in which they are employed.
 

The last one is one of the biggest reasons for individual investor under-performance. The study done by Fidelity Investments should highlight this. Investors in one of the most successful mutual funds lost money during a period of time where the fund made 29% annually. According to Fidelity, investors would pull their money out of the fund during periods of poor performance, and send it in during good periods.

 · It’s all about expectations

Another big issue is expectations.

Before one get to a earn say $5-$7k/month an engineer need to go through 4 years of professional education including one or two summer projects before he is allowed to be even called an Engineer Trainee. Medical professional is required even much more rigorous training before one is allowed to even touch knives for first surgery. Then why do people think trading is any different if it were to give you $5-7k/month to start? It doesn’t take long before one starts to realize that trading is not easy as it seems on the surface (sadly after either account is wiped out or suffered a major loss.

Setting realistic expectations is very important. I’m a big fan of the “slow and steady” approach. Aim for many singles instead of few homeruns. Be patient. Be prepared to lose for a while – set your goal as capital preservation instead of doubling your account. Think about the risk first. If you take care of the risk, the profits will come.
 

Here’s a quick list of some things to consider as you write down your expectations and goals.
 

1. More traders lose more money than they make. The figures are a little off depending on who you talk to, but it is 80% to 90% (maybe more) who end up losers and leave the business altogether.
 

2. Only a small percentage of retail traders are profitable. The numbers get even smaller if you look at a 3-5 year average which measures consistency. Don’t get discouraged, we all fell off the bike before we learned to ride it right?
 

3. Paper trade first with a small amount of money. I always recommend members to paper trade everything first. This way you learn how to enter orders, adjust trades, and more importantly learn you’re your mistakes without losing real money. Then when you are ready to invest real money, keep it small. Prove yourself that you can make money with 10k, then increase it to 20k and so on, but do it gradually.
 

4. You will have losing trades. Too many people quitting after a streak of few losing trades. Losing money is part of the game, the trick is to keep the losses as small as possible.
 

5. Don’t expect to become financially independent. Don’t you think it’s completely unrealistic to expect a small account, say under $5,000, to generate consistent income to replace your regular job?
 

 · What is your timeframe?

Peak to valley, from June 1998 – March 2000 Warren Buffett’s Berkshire Hathaway lost over 50%. In the same period, the S&P 500 returned over 45% and the Nasdaq 100 returned over 315%. A new client said to me the other day “I’m in this for the long term, but if after a couple years I don’t see any gains then I’m going to tell you this isn’t working.”
 

That feels logical, as two years can seem like an eternity for clients that tend to check their account balances almost every day. On a separate side note, I believe this behavior is rooted in an investors tendency to not completely trust their advisor which is legitimate in a field chock-full of conflicts of interest and bad advice which can largely be eliminated by a fiduciary standard.
 

But historical and statistical evidence suggests that even the most efficient strategies and portfolios are almost guaranteed to have a period of losses or no growth that last at least a couple years during any investor’s lifetime. Nobody can predict when that will happen. Does the fact that Warren Buffett underperformed the S&P 500 by almost 100% and the Nasdaq 100 by more than 350% for almost a two year period matter, or does this matter?

 · Conclusion

Most retail investors get greedy and panic at worst possible times. This is due to the basic fear/greed mechanism. People (professionals included) tend to over-project their optimism when things are good. And people tend to get depressed, bipolar when things hit the fan, leading to irrational actions. And they let their emotional state project itself onto their investing decisions, leading to missteps.

Kim Klaiman is a full time Options Trader and founder of steadyoptions.com – options education and trade ideas, earnings trades and non-directional options strategies.
 

Read more from Kim on his Options Trading Blog.
Twitter: @SteadyOptions_