There are many reasons why the average stock market investor loses money. Some loses are unavoidable and some are. One of the biggest mistakes investors make is trying to predict the direction of the market combined with their desire to be right most of the time. Here's why.
Most stock traders are very successful people and have a track record of being right most of the time. However when it comes to stock trading, the urge to be right, combined with exceptional intelligence can lead to financial disaster.
Unsuccessful traders believe they are smart enough to be right most of the time. When a trader spends a lot of time analyzing the market and tries to predict the direction of future prices based on what they know, it can be hard to admit they are wrong. When prices start going in the opposite direction, the tendency is to stay with the trade instead of getting out with a small loss. It's easy to rationalize, hope, and dream that prices will soon reverse. When prices continue to go against the trader, it becomes harder and harder to take a loss. Finally the trader admits with disgust, embarrassment, anger, and all sorts of negative emotions that they need to get out of the trade before they lose everything. The desire to be right causes unsuccessful traders to stay in losing trades too long.
Successful traders understand that they are smart too, but in spite of this they will be wrong most of the time. They don't have a need to be right and they don't believe they can predict the future. All they know is that they have logical entry and exit points where the risk is small compared to the possible reward.
Before they get into a trade they've decided where they'll get out if they're wrong and where the minimum profit target is. If the trade is worth taking they get in and relax. They've accepted the fact that either going to make money or lose it and they're ok with the possibility of taking a small loss if they're wrong. They know that losses are a cost of doing business and the secret to making money is to keep your costs low.
But this is only part of the profit equation. Finding entry points is the easy and fun part of trading. The hard part of trading is trade management. That is, what will you do after you get into a trade? When will you take profit? How much money you make in the market doesn't depend on where you get in. It depends on where you get out!
First let's look at our unsuccessful trader who's losing money because they need to be right most of the time. Firstly they stay in losing trades much longer than they should. Secondly they get out of winning trades too soon because they're afraid that prices might go against them and if they do, they'll be wrong. The desire to be right causes them to exit trades impulsively with a small profit rather than let their profits run. The combination of staying in losing trades too long and getting out of winning trades too early causes traders to lose money.
Successful traders are successful because they do just the opposite. They get out of trades with a small loss if they're wrong. And they let their profits run. Yes some winning trades will turn against them. That's why they're wrong most of the time. They might get out at break even or even with a small loss. But a small percentage of their trades will turn out to be huge winners. As a result, over a large number of trades, their trading account grows larger and larger. The key to making money in the market is to keep your losses small in relation to your profits.
The best traders in the world are smart enough to know they will be wrong most of the time and they're ok with it. They know that over time they will make money because their average profits are far greater than their average losses. Being wrong most of the time doesn't matter to them. Small losses are easier to handle once a trader experiences large profits and their account size is steadily increasing. Successful traders are more concerned with making money instead of being right or predicting the market's direction.