The need to learn from peers
There are plenty of stories out there showcasing how professionals mess up – traders, money managers or brokers losing gigantic amounts of money under harrowing circumstance, portraying hubris, incompetence, neglect or outright fraud. James Dearden’s movie “Rogue Trader” on Nick Leeson, the drunken oil futures trader Steven Perkins, or tales of risk officers sitting on toxic CDO waste dump balance sheets in the 2008/09 financial meltdown, such as for the infamous Lehman Brothers, Inc., come to mind.
As entertaining these stories might be, they do not provide any material benefit to the individual “investor“/speculator other than generating a collective outrage over “the System” and Wall Street at large.
I believe that for such market participants, it is much more insightful to look at the shortcomings of their peers to learn what’s crucial to avoid in the markets – suffering and learning vicariously in a context that matters, so to say.
Here, I’ve collated a small handful of extravagant and reckless personal boom & bust journeys, or plain sad stories of people trying to build a nest egg, in order to highlight common themes in what amateurs do wrong participating in the stock market (or really, any financial market).
Two of the curious things that characterize the stock market are that the way to success lies in doing almost everything exactly the opposite that amateurs do it or our impulses tell us, and that the nature of the stock market never changes.
The former is due to the fact that success in the markets is predicated on emotional discipline, and only to a smaller degree technical skill. The latter is, in really, due to the same thing. As human nature never changes, so won’t the stock market – because the stock market consists of humans acting according to their nature.
And once you spend some time in the markets, you will realize that almost all mistakes made by both professionals and amateurs are caused by some or other failing of us to control our human nature and impulses.
The stories here contain some of the more obvious mistakes people make in the markets due to lack of skill, discipline, or both. It is by no means a comprehensive list, but should serve as a good teaser to the topic.
A farmer’s nightmare
Let’s start with a shorter story to warm up. This one is about Yang Cheng, a Chinese farmer (read the brief story here) who lost his life savings in stocks. In 2015, he piled into the stock market after the government promoted equities to individual speculators in a wider effort to stoke economic growth. In late 2014 and 2015, the Shanghai Stock Exchange (SSE) Composite went on a strong up-trend to grow roughly 150% from its 2014 levels, which is out of the ordinary for stock averages but not also not unheard of in emerging market environments.
Yang put his savings, plus some money from relatives, and later some more borrowed money from his broker into shares of a local mining company. During the SSE market collapse in 2015/16, share prices tanked and with it all his money and then some. This story is somewhat reminiscent of all the mom & pop “investors” who lost a money in the dot.com bubble, and I will dissect a few of Yang’s larger mistakes below.
1) No loss cutting. You’ll see this one repeat for every example – for financial survival in the markets, getting out when one is wrong is the single most basic requirement. Being wrong means losing money, and you’ll be wrong a lot. Take a scar over an amputation. If you can’t do that, you should not participate in the market. From the outset, you need to set an amount of money (or a statistically viable percentage) that you are comfortable losing in the event that you were wrong – and get out when it is hit, no questions asked. When you sell at a pre-determined small loss, you are not causing or taking a loss … you already have the loss at that point. Now, you are just saying ‘no more‘, you are cutting off an even larger potential future loss. Think about it. If you don’t, sooner or later you will become victim of the snowballing effect, because every 50%, 80% or 99% loss started as a fledgling 5% draw-down. This is never the first thing on people’s minds, especially not self-proclaimed “long-term investors“, but it should be.
2) Entire stake bet on a single idea. Although I am not a proponent of what people classically mean when they talk about diversification, putting all your money into a single idea is just not sound from a risk management perspective, not even for a pro. Respecting risk is paramount at any juncture in the market, as a single bad piece of news can depress a stock substantially.
3) Putting your money on something you know. While that Peter Lynch mantra may work for some buy & hold-for-decades speculation styles in established large-cap companies in the US, it is highly unlikely to work for an amateur buying stock in small regional mining companies in rural China. In the context of active stock picking it will statistically only rarely lead to out-performance. And let’s face it, Yang was here trying to pick stocks, which was not in the realm of his competence.
4) Borrowing money as an amateur. Using leverage i.e. borrowed money, whether that’s in form of margin or derivatives, is a highly advanced high-risk tactic valuable only to those that are skilled enough to see when a market is sufficiently benign that reward outweighs the risk, and demands extremely stringent risk management … because leverage does not only work to the upside, but also amplifies losses. Yang borrowed more than ~$1 million from his brokerage on a ~$164,000 account, and when the tide turned, the pendulum swung the other way with might, multiplying his losses. After this episode, Yang owed about the same amount of money to his broker that he originally called his life savings.
5) Listening to advice. Yang listened to recommendations, tips & external advice. Listening to tipsters or taking advice never works, because in 99% of cases, advice is given by those that use a strategy that is fundamentally different and incompatible with our own, and the receiver does not possess the tools to properly use the advice. Time-frames, entry rules, exit rules and the bulk of necessary technical know-how is not passed on with the advice, making management impossible. And of course, it might be bad advice in the first place, or the counterparty might not use a strategy at all, being another amateur. Worse, it was advice from his broker. Never listen to people who make money off your market activities, especially if they act nice and helpful. Further, by his own admission, Yang saw that the market had become frothy in 2015, but he let “public opinion on government policies affect his judgment”. Another example of why we need to isolate our minds and only look at what the market tells us.
Similar elements carry over into the next story.
Robin Hood is no saint
The comedy “Trading Places” gives a satirical representation of the brokerage industry. The newcomer William is introduced to Duke & Duke’s firm with the words “No matter whether our clients make money or lose money, Duke & Duke get the commissions”. This has been true since the early days of this business, and recent more tech-enabled firms are no exception.
The online and smartphone brokerage app Robinhood Markets, Inc. appeared on the scene in 2015, but never really lifted off until the COVID pandemic in early 2020. Combine hundreds of million people stuck at home in lockdowns, stimulus checks in the mail and central banks aiding markets by pouring gasoline on the bonfire of market liquidity, and you have a winning recipe for producing unprecedented amateur trader market exuberance.
In this 2021 story, an anonymous amateur trader brought the mantra of ‘work hard, play hard’ to the stock market. “I just needed to do something else to kind of take my mind off of work”, he stated, to get some sort of work-life balance. “Investing seemed like a thrilling, fun journey” – and Robinhood would punch his entry ticket.
He proceeded to take increasingly large amounts of money out of his savings and threw them at trades that are best described as impulsive gambling, followed by a massive purchase of Alibaba derivatives that he believed to be a “safe bet”. Well, the market showed him that there is no such thing as a safe bet, and he proceeded to lose $400,000, most of his savings, in his dabbling efforts to do something “thrilling” after work. When price dropped, he did not cut his losses, and instead argued that price should rebound soon, buying more.
Similar elements from the story above appear – he put excessively large amounts of money on single positions (75% to 100% of his money), used leverage in form of derivatives, and did not control risk – no regulation of exposure in response to the market, nor cutting losses. His expected “limited amount of risk” in his “safe bet” became an excessive loss instead, eating the bulk of his life savings.
On top, he used hot insider “tips”, youtube videos, idiotic narratives pulled from the WallStreetBets forum and analyst ratings (all types of tipsters and external advice!) to justify buying but also holding his positions into deep losses. His for a losing trader typical defense of buying a dropping stock due to a low valuation metric is something I’ve previously dispelled as useless to individual speculators.
He made another large mistake, which is known as “averaging down”, i.e. buying more of a stock when its price declines. This is dangerous, as you are buying into a stock with down-trending price, and trends in stocks, like Newton’s first law, tend to continue in the same direction. Richard Wyckoff shares an insightful story “I recall a friend who, after seeing Union Pacific sell at $291 in August, 1909, thought it very cheap at $185 and much cheaper at $160. That made it a tremendous bargain at $135. He bought at all those figures. But at $116, his capital was exhausted, and, as they put it in Wall Street, “he went out with the tide”. Don’t average down, just don’t.
Finally, the anonymous amateur did not learn from his losses. Once his account was ground down by an >80% loss, he started to revenge-trade – trying to force the market to “earn all this money back”. Needless to say, you can’t force the market to do anything, and he lost even more on that late crusade.
A surprising number of stories go like this, for example this guy that shorted a meme stock all-in into an earnings report and lost his life savings. There was a huge appeal in trying to dabble in stocks in 2020 and riding on the ever-lasting wave of central bank quantitative easing. But for every amateur that made money on Gamestop, AMC and the other meme stocks in 2020, there is an army of people who lost all their money and then some on these trades.
And odds are that the few traders that were profitable lost it all later in the ensuing bear market of 2022. They made their money with flawed and heavily leveraged strategies used in a once-in-a-generation booming market environment. Continuing to use such strategies when coming into a market that does correct heavily and produces few actionable trends, will have blown up all their profits again, and likely more.
Meanwhile, Robinhood’s and many other brokerages’ eagerness to provide high leverage to complete amateurs, “gamification” efforts including confetti animations on order placement, and the general popularity of the stock market with amateurs should have been a sign to the astute observer that the market was severely overheating and close to a top.
Boom & Bust
The Guardian outlines an interesting read about an individual speculator that got into stocks just around the same time. It’s a typical story of a personal boom & bust cycle during an overheating market.
In the introduction of the story, the amateur trader is falling for the fallacy that one needs to start off with large money to make money in the stock market, which typically and also in this case drives amateurs into using high leverage and derivatives that later go against them. A great strategy consistently applied precludes the necessity for having large amounts of money to start off with, although of course more starting capital leads to higher absolute returns.
Again, previous elements of mistakes appear in the story – excessive concentration into single positions, complete lack of loss cutting, using high leverage, betting on your own insular opinion and tips from online forums … but in this case the trader actually managed to amass quite some returns, at least Initially. He turned his $15,000 into $1,2 million, and in moments of complacency and arrogance he details how he half-jokingly told a hedge fund billionaire to “call him for ideas”. Hubris comes before the downfall, as even many professional money managers have to learn. “I’ll race you to a million”, he texted a friend near the market top in 2021 … and then his luck ran out quickly.
A great mistake of his was that he had no rules in place for taking profits, which lets impulsivity and negative emotions take over, and usually leads to a loss of profits. He talks about states of euphoria, fear, anxiety, desperation and drunken optimism, ignoring a gut feeling to sell, then anger and regret with himself for not selling in time and sitting on a large loss. As in the above example, he did not cut his losses, rode a down-trend, and finally decided to revenge trade on random impulse buys to make his money back, thereby steadily losing increasingly more. Months later, he had lost all his profits, his initial $15,000, and to boot sat on >$50,000 in debt.
That’s how quick something seemingly good can vanish again, and shows the importance of not just having a way to get in the market, but also to get out and stay out. Millionaires are not made by the money made in great markets, but by the money kept in bad ones.
Use these examples to learn from other people’s failures – it’s the cheapest way possible. Unfortunately, most aspiring traders and investors try to reinvent the wheel, believe that they’re better than those who came before them, that the rules don’t apply to them, that “this time it’s different” of course, or who simply can’t learn from something they haven’t experienced themselves.
Well, the market sure doesn’t care. The tuition fee of this university can be very high, and one should not hesitate to try to use other people’s tales of caution as stepping stones on the road to success.
If you’re interested in learning more intricately about what to avoid when navigating the muddy waters of the market, check out my educational content!
