The investor’s chief problem-and even his worst enemy is likely to be himself. Benjamin Graham
Evidence shows that over active traders consistently under perform those who trade less often.
Knowing when to stay out of the market, and when to take risk “off the table” is a key skill that needs to be learned.
Brokers, dealers and other middlemen all make money from turnover. But over trading is not just bad because of the extra fees – there are other reasons too.
Having insight into the behavioral problems of over trading can give you a big advantage over others.Over trading. Why trading too much can be bad for your wealth Click To Tweet
What It Means to “Over trade” the Market
The best definition of over trading is that it means frequently departing from a trading plan – or worse having no plan at all. In other words it means opening lots of “unplanned or poorly planned” trades. Refusing to cut losing trades also falls under this category.
Trading can be compulsive and even addictive – that’s why we have to be constantly alert to the problem.
Obviously, some strategies, by their nature involve more frequent trading than others. But over trading, means departing from a plan. There can be many causes.
Over confidence • One common hazard the new trader faces is over confidence. Research shows over confident traders open more trades and hold on to more positions than those who’re more experienced.
If it isn’t nipped early, over confident trading can turn into gambling. This type of trader is often in denial and juggles a large number of losing positions believing at some point some or all of them will become profitable.
Behavior • Understanding psychology and suppressing certain behaviors is something many professional traders try to do. For example the “disposition effect”, as it is called, is something many traders and investors are guilty of and that professional try to avoid. This is the tendency to hold on to losing positions for too long while cashing winners too quickly.
Over analyzing • Numerous studies of real traders have shown that over analyzing positions and frequently monitoring performance actually encouraged bad practices like over trading.
In the past, it was assumed that all players in financial markets apply rational decision making – leading to efficient markets.
Yet studies in behavioral finance show this to be incorrect. People simply don’t act this rationally, at least not all of the time.
One reason, psychologists tell us, is that innate behavioral patterns will often trump rational decision making. Even when we’re aware of what’s going on and bringing this knowledge to bear it is difficult if not impossible to control these motivations because they are so instinctive.
For example people have an strong compulsion not to realize losses. Even if this harms their overall objective of making profits.
We have a bias towards holding on to losing positions and closing out profitable ones too early. The opposite of what traders should be doing.
In other words, the pain of a financial loss outweighs the thrill of a win, even if that loss is smaller than the gain. This is called loss aversion. It means we need to fight the urge to hold on to loses.
These behaviors aren’t limited to inexperienced traders either. Several studies have been carried out analyzing both institutional clients and discretionary traders’ positions. They show consistently that losing positions were on average held longer than winners.
Over trading can have several negative consequences:
- Over active traders often don’t have enough time to weigh up outcomes
- Increased trading costs due to unnecessary and unprofitable turnover
- Additional time and resources needed to maintain and supervise
- Fatigue and higher chance of mistakes
- Higher margin requirements
- Unnecessary and often high risk exposure
- The “opportunity cost” of missing profitable trading situations when they arise
Perhaps the last one is the most important. The opportunity cost means that when your account is full, you may not have free capital to trade when a real opportunity arises.
Where do Pros have the Edge?
One area institutional players have an advantage over independent traders is in access to information. They have an abundance of information all around them
This is from strategists, research teams, trading peers, sales, clients and so on.
Professional traders will be challenged and may have to justify their reasons for holding a position. As well as trades that are not consistent with a current market outlook. Traders working independently don’t have this peer scrutiny. This makes self-motivation and awareness a key aspect of success for the independent.
Moreover, good risk controls should prevent proprietary trading from extending into dangerous speculation – though of course there are plenty of examples of where this goes wrong.
Independent traders don’t usually have these checks and balances or information at hand. However many good resources are still available if you’re prepared to do the leg work to find them.Why trading too much can be bad for your wealth Click To Tweet
Practical Tips to Avoid Over Trading
- A plan. Having a trading plan isn’t going to guarantee success. But it is easier to check and correct when things go wrong.
- If you can’t avoid the compulsion to trade consider having two accounts. Use a secondary, risk account for more speculative trading.
- Good risk management will ensure losses are cut quickly and the account isn’t overexposed.
- Keep a journal. This will help to track progress as well as decisions that went wrong.
- Plan the trading week in advance. Take note of the economic calendar ahead and determine how any releases may impact your positions. This will help to avoid panicked trading decisions.