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The Hard Science Behind Why New Day Traders Fail: How Long-Term Investing Produces Greater Returns

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Day trading is when an investor buys and sells the same stock on the same day, which can occur in any marketplace (but is particularly common in the foreign exchange and stock market). Over 97 percent of daily trading activity derives from individual investor accounts. Moreover, performance measured over six months found that eight out of ten-day traders loses money. While those numbers can be discouraging, it should serve as a measure of caution for new traders lured into this activity from marketers advertising “fool-proof strategies” and “surefire signals.”

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In a 2011 research study titled "The Behavior of Individual Investors," UC Berkeley Professors Brad M. Barner and Terrance Odean found that individual investors who trade both actively and speculatively without a diversified portfolio lost money over time.

Lack of Knowledge

Random occurrences of success can trigger an irrational sense of confidence (even if they have no idea why they were successful).

The first time I day traded, I won big. I purchase a call option before the earnings call of a retail hardware supply company appreciated over 300% in a single day. While that may sound exciting, this was probably the worst thing that could have happened to me as a new trader. Not only did I develop a little sense of confidence after that win, but I also proceeded to gamble away my entire trading account, desperately seeking to strike gold a second time – which never happened. I had a minimal amount of knowledge, attained quick success, and overestimated my personal ability to produce results.

How the Dunning-Kruger effect impacts new traders

Researchers have identified this as a problem of metacognition or the inability to analyze your performance effectively. The Dunning-Kruger effect concept is a model developed by Cornell University psychologists David Dunning and Justin Kruger. They found that individuals who know nothing about a topic growing increasingly confident when they gain even the slightest bit of new knowledge subject (referred to as the "Peak of Mount Stupid"). As the novice gains a bit more information on the topic, they realize how much they don't know and wallow into the "Valley of Despair." Over time with more knowledge and competence, the individual finds themselves on the Way of Enlightenment" and regains their confidence in the subject but never higher than the initial enthusiasm they once experienced when they had no idea on the topic.

Investors should consider this model and temper enthusiasm on risky investing strategies such as day trading until they know the knowledge to consider themselves competent on the subject. Avoid overconfidence and approach each new endeavor with humility and the readiness to learn, grow, and evolve. Give yourself room to make mistakes and stay away from get-rich-quick strategies that promise fast returns.

After nearly losing everything I had saved over the years, I decided to take a step back and educate myself on proper risk management and focus on longer-term value investing and safe option strategies.

Lack of Experience

Knowing the right strategies to employ Is not enough for new traders as experience plays a crucial role in successful day trading. Experienced day traders take their jobs very seriously and remain disciplined throughout the trading session. These traders stick to their core strategies, set stop-loss orders, and effectively manage risk, preventing one or two bad trades from completely wiping out all gains. This process requires a mindset of discipline developed over time. While books, seminars, and courses will teach you the fundamentals of investing, they will not prepare you for day trading's rigorous mental exercise. New investors can focus on practicing patience, managing emotions, and understanding market psychology are three things you will need to master to be successful at day trading.

Practicing Patience

Being patient is difficult for most new traders. After all, most new traders come to the market with hopes and dreams of acquiring quick returns. The truth is that developing patience is essential for successful trading, and patience comes with experience. Follow your trading plans and ignore news and external factors that look to influence your emotions. Maintain the bigger picture in mind, focus on continuous improvement every day, and avoid making decisions based on short-term market moves.

Managing Emotions

Day traders experience a myriad of emotions throughout the trading session, including fear, uncertainty, greed, anger, hope, and regret. Quantify your feelings and determine what types of market moves trigger each one. Create if/then agreements as a part of your trading plan and execute accordingly (example: "if stock XYZ fails to break the two-week supply level today, then I will sell it at my limit order"). Be kind to yourself and allow room for mistakes. There are no perfect traders, but there are disciplined and profitable ones. To become a part of this class, managing your emotions is critical.

Understand Market Psychology

Having a keen understanding of what moves the market is imperative for day traders as investor sentiment can often drive market performance in a direction that is contrary to market fundamentals. The market movement does not always make sense to everyday investors, so understanding the why is just as important as understanding how. Most days, traders do not understand market psychology and allow short-term unfounded price action to determine their fate.

Conclusion: Should New Investors Try Day Trading?

While the allure of day trading may make it an attractive proposition for many new investors, studies have shown that individuals who focus on long-term investment strategies are more successful than day traders. If you look at market performance over the past several decades, you will see that a long-term market position has yielded astounding gains.

The S&P 500 Index itself has produced an Average Annual Return (AAR) of 10%-11% since it was inception in 1926. Considering the extensive studies on the paltry returns by most day traders, investing in long-term value stocks may be the best bet for new investors.