Wednesday 22 November 2017

Before you dip your toe in the equities pool, look at how professionals work

Peter Brown

Why do most investors and traders lose money? The answer is that we behave like humans in the financial markets.

Human psychology is poor when it comes to making investment decisions and very poor when managing them in running.

The typical human pattern is to take small profits quickly and to freeze into big losses. We have all experienced this. Some individuals have as high as a 70pc win-to-loss trading ratio and still have lost money.

Freezing into losing traded positions and investments is very common. Some notable examples are Nick Leeson who brought down Barings bank, John Rusnak of AIB fame and the Quinn family.

When the trade passes the point of 'I-can't-take-a-loss-that-big' the final outcome is nearly always total wipeout. Most of us have trades like that.

Who sold their bank shares and took a loss as they started to fall? Who has an out of the money position on a stock, which they have decided is now a 'strategic investment'.

The fact is human beings find it difficult to acknowledge a mistake and cut it out before it is too late. We do not have a trading plan and we have not learned the skills to survive in the financial markets.

Mostly we rely on brokers and advisors who are sales people that earn commission every time we deal. They are motivated and re-numerated by our turnover and not whether we make a profit.

Sometimes it is necessary to transact through these people but the onus is on us to understand what we are doing.

If so many people lose, surely it would be great to be able to underwrite their positions in the market and make the money they are losing.

Have you ever paused to think of how much the infrastructure of the markets costs and where the money to pay for it comes from?

It comes from high commissions and losing traders. The financial markets are a poker game; somebody has to pay into the pot for the professionals to profit.

The losing traders prove to us that big money is available in the financial markets. The fact that they are losing it proves that the opportunity is there to make it. We just have to have the opposite trading approach.

In other words be prepared to lose frequently to find the big winners. That may sound aspirational but in fact it is what professional traders achieve.

There are certain principles and methodologies you need to master in order to succeed.

These are not as complicated as people might think, they simply involve taking the human emotion out of decision making, utilising the correct trading strategies, and trading in products that are possible to make a return from.

Simply put, trading on price action using small amounts of capital, rather than investing in risky assets. Professional traders are extraordinarily risk-averse, typically only exposing 2pc of their capital to the market at any one time.

They place small bets on price movement, avoiding big losses but making multiples of their bet. In this way they achieve a great return on their capital even if their success rate is less than 50pc.

In contrast, most people see investing as 'stock picking'. This is a ridiculously high risk, futile exercise in trying to predict the future.

The price of an equity today reflects present and future performance of a given company, therefore any movement off today's price has to be a surprise to the investor.

The process is purely a gamble which exposes large amounts of capital to the market and attracts high entry and exit fees.

Some 'stock pickers' are lucky and their success stories prolong the myth that this traditional activity is a proper way to invest. At present there is an 80pc correlation between the S&P 500 and the stocks that make up the index. So why not trade the index?

Modern technology has brought the markets to our fingertips.

Tools such as Technical Analysis and Spread Trading Platforms allow us to see market movement and transact instantaneously.

With the right education individual investors/traders can exploit the markets for profit, tax free. The uneducated will remain, their capital exposed to the market and reacting with human emotion.

Peter Brown is a founder and teacher at the Irish Institution of Financial Trading. For further information visit www.iift.ie or call 01- 6644034

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