What is the Number One Mistake Traders Make?

Big financial market volatility and growing access for the average person have made active trading very popular, but the influx of new traders has met with mixed success.

There are certain patterns which may separate profitable traders from those who ultimately lose money. And indeed, there is one particular mistake that in our experience gets repeated time and time again. What is the single most important mistake that led to traders losing money?

Here is a hint – it has to do with how we as humans relate to winning and losing

Our own human psychology makes it difficult to navigate financial markets, which are filled with uncertainty and risk, and as a result the most common mistakes traders make have to do with poor risk management strategies.

Traders are often correct on the direction of a market, but where the problem lies is in how much profit is made when they are right versus how much they lose when wrong.

Bottom line,traders tend to make less on winning trades than they lose on losing trades.

Before discussing how to solve this problem, it is a good idea to gain a better understanding of why traders tend to make this mistake in the first place.

A Simple Wager – Understanding Decision Making via Winning and Losing

We as humans have natural and sometimes illogical tendencies which cloud our decision-making. We will draw on simple yet profound insight which earned a Noble Prize in Economics to illustrate this common shortfall. But first a thought experiment:

What if I offered you a simple wager based on the classic flip of a coin? Assume it is a fair coin which is equally likely to show “Heads” or “Tails”, and I ask you to guess the result of a single flip.

If you guess correctly, you win $1,000. Guess incorrectly, and you receive nothing. But to make things interesting, I give you Choice B—a sure $400 gain. Which would you choose?

Expected Return

Choice A

50% chance of $100050% chance of $0

$500

Choice B

$400

$400

From a logical perspective, Choice A makes the most sense mathematically as you can expect to make $500 and thus maximize profit. Choice B isn’t wrong per se. With zero risk of loss you could not be faulted for accepting a smaller gain. And it goes without saying you stand the risk of making no profit whatsoever via Choice A—in effect losing the $400 offered in Choice B.

It should then come as little surprise that similar experiments show most will choose “B”. When it comes to gains, we most often become risk averse and take the certain gain. But what of potential losses?

Consider a different approach to the thought experiment. Using the same coin, I offer you equal likelihood of a $1,000 loss and $0 in Choice A. Choice B is a certain $400 loss. Which would you choose?

Expected Return

Choice A

50% chance of -$100050% chance of $0

-$500

Choice B

-$400

-$400

In this instance, Choice B minimizes losses and thus is the logical choice. And yet similar experiments have shown that most would choose “A”. When it comes to losses, we become ‘risk seeking’. Most avoid risk when it comes to gains yet actively seek risk if it means avoiding a loss.

A hypothetical coin flip exercise is hardly something to lose sleep over, but this natural human behavior and cognitive dissonance is clearly problematic if it extends to real-life decision making. And, it is indeed this dynamic which helps to explain one of the most common mistakes in trading.

Losses Hurt Psychologically far more than Gains Give Pleasure

Daniel Kahneman and Amos Tversky published what has been called a “seminal paper in behavioral economics” which showed that humans most often made irrational decisions when faced with potential gains and losses. Their work wasn’t specific to trading but has clear…



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