Ninety-five out of one hundred investors lose money trading. One reason for this is that like novice horse-riders they are just very bad at it. However, horse-riders can practice until they get better but traders stop because they run out of money (I know I did).
So why is it that smart people can lose money so quickly?
You won't get average returns when trading
Those of us who can remember our high school maths may remember that a set of results such as investment profits has a mean, median and mode.
Mean profit (or Ensemble average)
The average profit of many trades
The middle result in the list of results arranged from smallest profit to biggest profit
The most frequently made profit
You might also remember that the results of a set of purely random events will form a Normal Distribution which looks like a bell. For the Normal Distribution the mean, median and mode are all the same which is either interesting or boring depending on your viewpoint.
However, real-world distributions like trade profits are not Normal Distributions and the Mean, Median and Mode can be very different.
For example, 1 million investors buy a lottery ticket for a $1. The winner gets $1m and therefore the Mean profit will be zero but both the Median and Mode results are to lose $1. We can see that if want to understand what OUR OWN experience is likely to be we must consider the Median and Mode experiences not the Ensemble Average. The statistics show that active trading is like this example; a few people make money while the vast majority don't.
At this point, you may well say “I have superior judgement so I will be the lucky winner”. In my view that won't happen because the markets are rigged but let's take that claim at face value.
Time Averages will kill you
In the words of Dirty Harry (sorry to the readers under 50),
Uh uh. I know what you're thinking. “Did he fire six shots or only five?” Well to tell you the truth in all this excitement I kinda lost track myself. But being this is a .44 Magnum, the most powerful handgun in the world and would blow your head clean off, you've gotta ask yourself one question: “Do I feel lucky?” Well, do ya, punk?
I are now going to show the role that bad luck has in trading and how it ensures your downfall over the long term.
We know that market contains some good investments, some average investments and some that are actually worth nothing. Obviously we can't actually tell which investments are worth nothing. If anyone could actually tell, word would get out and they would go bust. Our skill and judgement are not going to help us, we have to rely on good luck.
Let us say that 1% are worth nothing in the long-term (in venture capital markets such as crypto it is probably 99%!) and that if we buy them we will lose our whole stake become bankrupt and be out of the game.
Making a single investment is like playing a game of Russian roulette where the player loads a single bullet into a revolver, spins the chamber, points the gun at his head and fires. In our example we have 1% chance of a getting a bullet (bad investment).
The problem is that we don't only play the game once, we just keep spinning the chamber and pulling the trigger each time we make a trade. We might last 10 spins, or 100 spins or 1000 spins but eventually there is a bullet with our name on it.
The Time Average gain from 100 investments one after the other is very different from the Ensemble Average of 100 investments made at once. The Median and Mode returns shrink as time goes on – you will go bankrupt.
Index funds make money with less risk
I have shown that it is very unwise for anyone without insider information to trade actively. This is because active trading results in modal gains and is subject to Time Averaging resulting in you eventually losing all your investment.
If you insist on trading you can reduce these risks by diversification. In my Russian roulette example the investor choose only a single investment on each spin and was easily bankrupted. If he had chosen 2 investments the both would have to fail for him to be ruined. If he had chosen 10 investments on each spin, all 10 would have to fail. Successful traders will often have 20 active trades and a maximum of 5% of their bank roll at risk in any one trade.
So what is the optimum number of investments to avoid ruin? The answer is to buy a small amount of every investment on the market and the easiest way to do this is to buy an Index Fund. This ensures that you will get Ensemble Average returns before fees.
Trading is called “active investment” because you have to work to manage your holdings and worry about them. Owning index funds is called passive investment because you have to do anything to get average returns. Average returns are boring and boring is good.
My personal view is that the best conventional index funds are the Vanguard LifeStrategy range and the best Cryptocurrency index fund is Crypto20. Obviously crypto is many times more dangerous than conventional investments and many advisers would suggest it should not form more than 5% of your savings.
and because you don't believe me
The only way that most people (including me) to get it into their thick skulls that active trading is a waste of time and money is to try it. A few early wins and a bull run will convince them that they are genius traders and long-term experience will change their mind. Therefore, have a go, open an account and put in $1000 and see how long it takes to lose it. If you only lose $1000 you have done well, most people pay much more to learn the lesson.
I was prompted to write this post by this excellent article.