The Real Reason Traders Fail
Well-known research from Brad Barber and colleagues finds that active traders, as a whole, lose money in markets, with many persisting in the face of repeated loss. Indeed, the evidence suggests that only a very small proportion of day traders makes money year over year. Would-be educators suggest that the reason for such dismal performance is a lack of proper trading strategies; would-be coaches and mentors suggest that failure is a function of mindset. In this post, I will suggest something different: that trading is a business and traders fail for the same reasons as entrepreneurs who pursue startups.
In an insightful article, Patrick Henry cites research on the success rates of startups and the reasons for their failure. He notes that failure is common among startups, with 75% of venture-backed companies ultimately closing their doors. Among the most common reasons for failure were lack of motivation; lack of focus; unwillingness to learn; lack of mentorship; lack of business knowledge; lack of the right team; lack of cash; and lack of a sound business model. Conversely, Henry notes that startup successes display ongoing commitment; a willingness to adjust, listen, and learn; solid mentoring relationships; and a strong domain-specific knowledge base. Interestingly, the successful new businesses tend to start up in a lean mode, raising just enough capital for the next phases in their development. Their less successful counterparts raise too much money early on, burning through valuable resources early in their learning curves.
To appreciate how these findings might apply to traders in financial markets, imagine an entrepreneur starting up a restaurant. We can imagine that several factors will be important to the success of the venture:
- Location – The same restaurant could succeed in one location and fail in others, depending upon the fit between consumer needs/interests and the restaurant’s ambiance, menu, prices, etc. A crowded location with many similar offerings is apt to be less promising, but a wholly uncrowded location might be uncrowded for a reason. The key is identifying areas of unexploited opportunity.
- The Right Products and Process – The menu must meet diverse customer needs and interests, and the execution must deliver food of consistent quality in a timely fashion. The right product begins with the right recipes, but it’s ultimately how the recipes are delivered as meals–day in and day out–that makes an impact on diners.
- The Right Business Plan – How will the restaurant evolve its menu? How will it grow as a business? How will it appeal to new groups of diners? Starting up and opening the doors is merely the first step. A sound business plan ensures that everything, from marketing to product development, is pursued in a thoughtful manner based on sound information, experience, and skill.
- The Right Team – As the business grows, no one can do everything all the time. Someone is needed to greet entering customers; staff is needed for the kitchen and to wait on diners; sources are needed for quality ingredients; assistance is needed for legal and accounting matters; etc. As a business grows, it truly becomes an organization, linking multiple people with different areas of expertise and requiring leadership in keeping the organization organized.
With this background, we can reflect upon independent traders and whether they possess these success ingredients.
- Location – Location for the trader is the set of markets and opportunities being pursued. Many traders search for oil in the same locations where others are drilling, reducing their odds of success. At SMB Capital, there is an emphasis on locating stocks “in play”, where volume, volatility, breaking news, and other catalysts create unique opportunity. The key message is that what you trade is every bit as important to success as how you trade. Many traders, like many startup businesses, simply locate themselves in the wrong places, minimizing their opportunity sets.
- The Right Product and Process – Years of working with traders on their performance have convinced me that a major predictor of success is the presence of multiple ways to win across various market environments. In some markets, the successful money manager will be long or short particular assets; in other markets, they may trade relative value or volatility among multiple assets. There is a rigorous process in place that determines how to optimally structure trades and how to balance a portfolio of opportunities. A great predictor of failure is an investor who looks for opportunity in one place, with one style of investment. Without a specialized body of knowledge and experience, it is difficult for a trader to make such adaptations.
- The Right Business Plan – Many traders experience initial success, only to fail when they try to grow their profitability and expand their risk-taking. The strategies that worked for getting off the ground may be very different from the strategies needed to make the venture consistently profitable. The successful business manages each day in a process-driven fashion, but also operates with a vision of longer-term opportunity and development. Many traders fail because they lack a sustainable growth plan, becoming torn in multiple directions when it is time to expand. Per Henry’s observation, they do not start up lean and lose too much capital early in their development.
- The Right Team – Imagine a restaurant where the owner attempted to be the chef, wait staff, dishwasher, marketer, purchaser of goods, and accountant. The solo trader fares no better, unable to keep up with multiple markets and opportunities amidst ever-changing news flows and competition from better-financed competitors. The individual investor needs resources from the right brokers; market analysts; and insightful colleagues. Note the emergence of large communities of traders, such as futures.io and Traders4ACause, which make vast resources available to independent traders and investors, including webinars; conferences; meetups; downloadable research; and networking among participants. Similarly, we see the increasing development of teams on trading floors at hedge funds and proprietary trading firms, where team members support the senior trader with their own unique skills and experience. Notice the role of mentoring among the successful startups reviewed by Henry.
As I recently emphasized, a great exercise is to imagine that someone came to you asking you to fund their trading, when their location of opportunities; strategies and processes; plans; and teamwork is exactly the same as yours. Would you invest in someone else if they were approaching markets the way you do? The odds are pretty good that the answer would be no. And that is the main reason traders fail: not because they are trading the wrong chart patterns or have the wrong frame of mind, but because they have not turned their performance activity into a sustainable business. Every great trader, at root, is a great entrepreneur. Looking at more charts, writing more journal entries, and conducting more self-help exercises will not substitute for building a foundation for success along the four dimensions above.