A Big Win: A Time to Splurge or a Time to Be Careful?
Recent election results had a positive impact on the markets? Did you profit? Did you have a windfall? Behavioral economists find over and over again that when people receive an unexpected windfall, they act as if it is free money. There is a strong tendency to put on trades unnecessarily, haphazardly, and without a specific plan. Overtrading doesn't usually pay off, however, as shown by Drs. Barber and Odean, in what
has now become a classic study in behavioral finance.
Barber and Odean studied trading patterns at a large brokerage. They identified overtraders based on the number of trades they made and examined the amount of profits each group realized over the course of a year. They wanted to see whether overtraders could beat investors who used a simple buy-and-hold strategy, which is a relatively conservative trading strategy. Average annual turnover was 250% for overtraders and 2.4% for buy-and-hold investors. It is quite interesting, however, that although both groups achieved an 18.7% gross return on their investments, the net return differed greatly. Due to commissions, the overtrading group had a net return of 11.4% while the buy-and-hold group had a return of 18.5%. Overtraders were more likely to make trades after a big windfall.
Even seasoned traders may struggle with overtrading. Consider what a seasoned professional told us in an interview with Innerworth staff. "I have always struggled with, and still struggle with, becoming overconfident. When I'm doing well, I tend to become complacent in the management of the money or protective stops. Or I tend to start trading bigger size just because I have the extra money. I also tend not to be as diligent when it comes to doing my homework. I become more whimsical."
"In contrast, when I'm really working on the trades, I ask questions like, Where did it open? Where did it close? If it opens higher, where's the floor going to open it higher? Where do I expect the commercials to come in? What's the volume? What's the scale? What does it look like on the weekly? What's it look like on the daily? I get into the details. My problem is when I'm happy and making a lot of money, all of a sudden I don't worry about the details."
What is the solution? What does he do when he finds he is becoming overconfident?
"The first thing I do is start looking to see if I'm making mistakes. The other thing I do is to use a trading diary, and write down why I made the trade. The problem with human beings is that we tend to deceive ourselves time and time again. A little deception is acceptable. But then we will forgive ourselves for our own self-deception. If I just keep it in my head, I can lie to myself. But if I write it down, I can't lie to myself."
It may also be useful to stand aside after a big win. "When I have a big windfall of profits, I stop trading for a few days. I take that windfall home with me. I try to figure out ways to keep it. I come up with new strategies."
One of the best antidotes to overtrading is developing very detailed trading plans. It is to your advantage to develop a specific trading plan and stick with it. Before you put on a trade, make sure your trading plan is clear. Identify the signals or indicators you will use to monitor the trade. Anticipate which indicators will signal when a trade is going against you. Justify your trading plan, and make sure that you have sound reasons for putting on a trade. Make sure you are taking advantage of a good setup, rather than impulsively acting on the urge to put on a trade. Through careful self-monitoring of your trading plan, you can reduce overtrading and the potential damage it can do to your trading account.
