Becoming number one is easier than remaining number one.
– Bill Bradley
There have been some upswings in the markets recently, more opportunities to win and take home quite a windfall. But beware, if you were one of the winners, then congratulations but know that your money is now at greater risk as behavioural economists have discovered that the general response to profits is to treat it as if it is a bonus that doesn’t need to be handled with care but much more as free money to be ‘spent’ with abandon.
In trading this converts into trading without a plan, and in greater percentage of capital than is sensible or that the same trader normally does. In short, the winner becomes an ‘overtrader’ and this is not the path to greater returns or overall profit for the long term.
I’ve spoken to a couple of broker analysts, Jason and Graeme who have studied the trading patterns of their brokerage house to see if they could identify what really happens when traders start overtrading and if there is a payback or not. Their aim was to quantify the difference for potential, if any, between the overtraders and those investors who operate on the more conservative methodology of buy-and-hold. They analysed the number of trades made, the resultant profit from each trade and the total profits made in a year.
The results they got were extremely revealing and confirmed that overtraders are most likely to trade after a big windfall. More interestingly though was that, whilst the overtraders showed an average turnover of 250% compared to 5.4% for buy-and-hold group, they both had a gross return of 16.7%. However, after deduction of commissions, the overtraders only showed a net return of 9.4% compared to the buy-and-hold investors who showed a net return of 15.5%. Quite a difference and something that should give all traders pause for thought as they consider all that energy used, and risk taken for a less overall return.
Everyone is at risk of overtrading (me included) if it is so closely aligned to getting a big windfall because it is hard to overcome the psychological response to the win. The feeling of invincibility and overconfidence lead to less focus on planning and strategizing, leading to complacency.
As one experienced professional trader told us “when I am doing well I tend to become more complacent in the management of money or protective stops…I tend to trade bigger sizes just because I have the extra money.” He went on to admit to being less diligent and focused compared to when he is a ‘normal’ state as he goes into detailed reviews of the stock, the company, the previous price range, the levels of resistance and support. When he is focused he goes through a long list of planning and strategy questions about where he expects it to open, what happens if it opens higher/lower, what are the standard volumes and what would he expect to see, what does the stock look like on the daily and weekly charts etc. All these questions prepare him mentally to watch the stock, ready to initiate the trade and for setting protective stops with a clear exit plan.
For this particular trader he has recognised the risk he runs as he becomes overconfident and has put in place a strategy to deal with it and put him back into a better place for planning a trade and trading the plan.
First of all he does a review of his recent performance and trades to see if he has been making mistakes. He also keeps a trading diary in which he keeps a record of what he trades and why, i.e. a record of his thought process and strategy which means that when he reviews a trade he has to be honest with himself as to what his motivations were if it goes wrong.
This is perhaps one of the best things to do as a standard practice as the process of writing it down can make one stop and think about what we are doing and why. The final action of this particular trader after a big windfall is one that everyone else should also consider as he stops trading for a few days and transfers the profits to somewhere ‘safe’ while he works out new strategies and whether it gives him new and greater opportunities. This pause for thought means that he is less at risk of overtrading and thus more likely to turn the windfall into a greater profit in the long run.
What this shows us is that everyone is at risk of overtrading but the there are strategies to reduce this risk through proper trade planning. Going from the start to the end of the planning process in an organised fashion will ensure that you have everything identified from entry point to exit strategy, protective stop level and what you will use to monitor the trade.
Moreover you will have a justification for the trade and will be able to explain to yourself and others the rationale behind each trade. This dramatically reduces the risk of impulsivity and the risks of overtrading.
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