Why Most Discretionary Traders Fail
In the world of trading, there are generally two schools of thought: discretionary trading and rule-based trading. The distinction between these approaches can significantly impact a trader's success
Discretionary trading involves making trades based on current market conditions and subjective judgment. While this approach allows for flexibility and instinctual decisions, it also opens the door to a myriad of pitfalls that can lead to failure. Several market research studies and academic papers shed light on the high failure rates among discretionary traders.
A significant body of research indicates that upwards of 80-90% of discretionary traders fail over the long term. For instance, a study by the University of California, Berkeley found that individual investors who engage in frequent trading significantly underperform those who trade less (Rotblut & Odean, 2014). Another study, published in the Journal of Finance, highlights that the vast majority of active traders lose money, with poor timing decisions and the impact of transaction costs being major contributing factors.
More academic research on the matter reveals that the high failure rates of discretionary traders are not specific only to retail investors but also apply to market professionals.
In 2012 Arnold, J., & Zaffaroni, P. conducted a study investigating the differences in survival rates between systematic and discretionary Commodity Trading Advisors (CTAs) over a 15-year period. They found that systematic CTAs have higher median survival than discretionary CTAs (12 years vs. 8 years). The study suggests that discretionary CTAs face a higher failure rate compared to their systematic counterparts.
The reasons behind these stark statistics are multifaceted. Discretionary trading often leads to emotional decision-making, resulting in trades driven by fear or greed rather than rational analysis. Additionally, the lack of a structured approach makes it difficult to evaluate performance objectively and learn from past mistakes. Market noise and information overload can also lead to analysis paralysis or impulsive decisions that deviate from a sound trading plan.
The Case for Rule-Based Trading Systems
In contrast to the discretionary approach, rule-based trading involves following a set of predefined criteria for entering and exiting trades. This method brings several advantages that can address the shortcomings of discretionary trading.
Firstly, a rule-based system helps to eliminate emotional decision-making by adhering to a systematic approach. This can significantly reduce the psychological stress associated with trading and help maintain discipline in the face of market volatility. Additionally, having clear rules in place enables traders to backtest their strategies against historical data, providing a more objective assessment of their effectiveness.
Moreover, rule-based trading promotes consistency and repeatability, which are critical for long-term success in the markets. By applying the same criteria across all trades, traders can more reliably evaluate their performance and make data-driven adjustments to their strategies.
Why Avoiding Discretionary Trading Might Be the Right Choice
Given the high failure rates and inherent risks associated with discretionary trading, it might be wise for traders, especially those new to the markets, to avoid this approach. The lure of making quick, instinct-driven decisions can be strong, but the evidence suggests that this often leads to suboptimal outcomes.
Embracing a rule-based trading system can provide a more sustainable path to success. It offers a structured framework that can help traders navigate the complexities of the market while minimizing the impact of emotional biases. Additionally, the discipline and consistency fostered by a rule-based approach can be invaluable assets in the unpredictable world of trading.
In conclusion, while the allure of discretionary trading and the promise of big wins can be tempting, the statistical evidence and practical considerations strongly support the case for rule-based trading systems. By adopting a disciplined, systematic approach, traders can enhance their chances of success and longevity in the markets.