How Can You Learn from Your Trading Mistakes?

MARK RIEPE: "Making predictions is hard—especially about the future." I'm not sure who said that. It was probably Mark Twain, as it seems like a very Mark Twain-ish thing to say, but whoever said it, they were onto something. And it's especially relevant because so much of investing is about making predictions about what we think will happen.

Of course, investing isn't the only discipline that requires making predictions. If you have a smartphone, you probably have a weather app on it. Sometimes you use it to check on what the weather is right now, but you mostly use it to tell you what the weather will be. There's nothing unusual about this—people have been trying to forecast the weather since ancient times. In fact, the word "meteorologist" comes from a book on weather that Aristotle wrote called Meteorologica, a combination of "meteor"—which was the Greeks' name for any particle that fell from the sky or was suspended in air—and "ology" which means "the study of."

I'm Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab. It's a show about financial decisions and the cognitive and emotional biases that can cloud our judgment.

The good news is that our understanding of the weather has come a long way since the ancient Greeks. The National Weather Service has a great webpage where they lay out the many, many advances that have been made in weather forecasting over the years and what led to them. As I was looking at the page, I was struck by the fact that so many of the advances were spurred by mistakes.

By that I mean, a severe weather event happened that was unanticipated. Lots of property was damaged, lives were lost, and policymakers and subject matter experts got together to figure out what went wrong with the forecast. In other words, they tried to learn from past errors.

Of course, this isn't just a U.S. phenomenon. In fact, given the complexity of weather, the more minds working on the problem, the better. Think about it: With barometric pressure, wind direction, wind speed, temperature, and countless other factors in a fragile and complex atmosphere, weather is notoriously difficult to predict.

The good news is that with steady innovation and a rigorous comparison of past predictions with what subsequently happened, weather forecasting is getting better. In fact, in 2015, the computer model favored by European countries gave six-day forecasts that were as good as its three-day forecasts in 1975.

So learning is a good thing, but despite the success of weather services, learning outside of school actually is difficult. Think about it. When you were a kid in school, learning was, ostensibly, your job. There was structure to the lessons. The lessons followed a progression and built on each other. The school provided an environment that promoted focus—think of a quiet library, for example—and you got feedback, for better or worse, from teachers and test results.

Now, I know our education system is far from perfect, and maybe I'm looking back on my Iowa public school education with rose-colored glasses, but all those conditions that make learning easier are hard to replicate when you're trying to learn about investing.

That lack of objective feedback is one of the big problems, and decision-making biases are one of the culprits. For example, if we see good past returns, did we get those returns because we were skilled, or did we get lucky? I suspect most of us lean towards attributing good trades to skill and bad trades to luck, specifically bad luck, or forces outside our control.

Amy C. Edmonson, a professor at Harvard Business School who studies, among other things, organizational learning, observed that "examining our failures in depth is emotionally unpleasant and can chip away at our self-esteem. Left to our own devices, most of us will speed through or avoid failure analysis altogether."

That unpleasant feeling can prevent us from learning from a mistake because, let's face it, who wants to feel bad? Of course, it doesn't help that markets are complicated, just like the weather. Even the experts are wrong a lot.  Nevertheless, learning is too important to just throw up our hands and give up, and Randy Frederick is here to help us get better at learning.

He's a managing director of trading and derivatives for the Schwab Center for Financial Research. Randy is a frequent guest on CNBC, Fox Business, and Bloomberg TV, and his reports often appear in the Financial Times, Barron's, and The Wall Street Journal.

Thanks for being here, Randy.

RANDY FREDERICK: You're welcome, Mark. It's always great to be on your podcast.

MARK: Randy, nobody's perfect. We all make mistakes. And I'm sure that over the years you've seen traders make lots of different types of mistakes. And that's what we're going to be talking about today. And I like to divide mistakes into two categories: We've got emotional mistakes, and we've got mistakes that are more cognitive in nature. So let's start with the emotional side: What are ones you see most often?

RANDY: They kind of run the gamut, but some of the common ones that come to mind are overconfidence. When everything you buy goes up, some traders start to feel like they're smarter than the market. I think many young people who just started trading following the COVID bear market in early 2020 fall into this category. If they got into the meme-stock trading at just the right time, they may have done very well. But those who got in a little later have experienced drawdowns several times worse than the market.

Overtrading. This can take many forms, but a common one is actively trading most or all of your portfolio. We kind of have a tendency to think of our clients as either investors or traders, but really, everyone should be an investor; it's just that some are traders, too. 

Buying at the highs and selling at the lows. This one seems so obvious, you wouldn't think we'd even need to discuss it, and yet it happens all the time. The most basic of all investing principles is buy low/sell high, but many investors tend to do exactly the opposite. Why does that happen? One word: emotions.

And lastly, playing the "all in" or "all out" game. I constantly get questions from traders of all kinds whether or not it's the right time to "get in" or "get out" of the market. My answer is always no; not now, not ever. No one can time the market perfectly and being entirely out of the market will almost certainly result in missed opportunities.

MARK: So that's a pretty good list and I want to come back to that list in a little bit. But before we do that, I think it's fair to say that most people, they make these mistakes, and you know we're all human, and we want to learn from mistakes and not make the same mistakes again, but I think what makes emotional mistakes difficult is, you know, they're hard to learn from since we know we can't eliminate emotions, that root cause there. So what advice do you have as to how we should be dealing with that?

RANDY: You're right—we can't. And the best way that I can think of to avoid repeating past mistakes is to avoid putting yourself in that same situation again. If being overly concentrated in volatile stocks caused you to make a bad decision, then don't let yourself get overly concentrated again. If taking on too much margin debt caused you to sell at the bottom to get out of a margin call, then don't get so leveraged again.

Because bull and bear market cycles tend to last for several months or even years, it's easy to forget what you did in the past, and why. One way that you can make sure you don't is to create a trading log. A trading log should list not only all of your trades, but also why you entered or exited each position. I created my very first trading log back in 1999, and I still use the same one today. Any time I want, I can easily see every trade I've ever done in every one of my accounts for the past 23 years.

Now one technique that might help also is what I call scaling-in and scaling-out. If FOMO, or the fear of missing out, caused you to buy too close to the top last time, you don't have to completely avoid that urge; just buy a lot less. Instead of buying 100 shares, maybe you just buy 10 or 20. That way, if it goes higher from there, at least you'll still feel like you're participating. And if it falls, you'll have reduced your risk by 80 or 90%.

Likewise, if the fear of a market collapse caused you to sell near the bottom last time, then just sell part of your position. If the market continues to fall, you can feel good that you've preserved some of your gains. And if it bounces back, you won't miss out on the rebound. 

You know, Mark, the key to all of these things, the way I see it, is moderation. Don't make huge drastic changes for any reason; make small strategic changes when the timing feels right. That way you'll have a little more room for error. If you time things perfectly, you'll still benefit, but if you don't, the consequences will be minor.

MARK: Yeah, I think that's good advice, especially that last point about "be aware of the downside" and make sure that the size of the trade fits what you're able to deal with, in terms of the consequences. Let's go back to your list, and the first item you mentioned was overconfidence. So give me a little bit more detail about why's that a mistake and what techniques have you found effective for reducing the incidence of that mistake and, of course, the damage that it causes?

RANDY: There's an old expression that goes something like this: "Don't confuse a bull market with trading expertise." This mistake rears its ugly head almost every time we get into a strong or a sustained bull market. As you know, the S&P 500® gained almost 27% in 2021, and every single one of the 11 market sectors was up; in fact, even the weakest sector delivered double-digit returns. 2021 was such a strong market that it was hard to lose on anything, unless you were shorting it. 

It really didn't take a genius to make money last year; if you bought the dips, you knocked it out of the park. Yet we all heard about the new market "wizards" who bought Bitcoin or meme stocks at just the right time, and now they're driving Lamborghinis. Social media influencers touted how easy investing was; there mantra was "stocks only go up." But we've seen this movie before. We remember when the internet bubble burst in early 2000, and we lived through the great financial crisis of 2008. Many of them, on the other hand, got into the market for the very first time near the COVID-19 bear-market bottom. They've never lived through a bear market.

Now of course, the S&P 500 has experienced a modest 10% correction, and the most popular of the meme-stock names like GameStop and AMC have fallen over 80% from their 2021 peaks, and that's far worse than the broader market.

MARK: All right, let's go to the next item on your list which is overtrading, and by that you don't mean so much the frequency of trading—it's really the amount of portfolio that is allocated to trading, is that right?

RANDY: Yeah, it could be the other, but in this particular case, that's what I'm talking about. You know, Mark, the bulk of the research and education my team does is focused on active trading and options trading. However, I regularly emphasize that active trading should be limited to no more than about 20% of your overall portfolio. And within that 20%, traders should also limit each individual trade to no more than about 5%. And the reason for that is that a 5% loss is one that almost any investor can bounce back from. Everyone makes bad trades, and you don't want to let any mistake put your long-term portfolio at risk.

The other 80% should be long-term focused and well diversified. At the end of most of my branch events, I encourage attendees to meet with a financial consultant to establish an asset allocation plan that's right for them. For investors, that would be 100% of their portfolio, and for traders, it should be 80% or more of their portfolio. Then at the end of each calendar year, you make small adjustments to get the portfolio back to its target allocation. That means taking some profits in outperforming sectors and buying a few shares in underperforming sectors. Since I'm a trader analyst, attendees are usually surprised to hear me say that. But I think it reinforces the idea that traders also need to be investors; they are not mutually exclusive.

MARK: Yeah, I think that's exactly right. The next one is my favorite: buying at the highs and selling at the lows. And I love it because at one level, it's very obvious—nobody wants to buy high and sell low. And, in fact, emotions make it very difficult to avoid doing that, right?

RANDY: Yeah, when the market gets overpriced, optimism is usually really high, and some investors get excited, and many of them feel compelled to buy due to, again, FOMO. Again, like during the meme-stock frenzy, they hear lots of stories about other people who are getting rich quick. The reality of course, is that there are usually far more who are losing money; you just don't hear about them as often. A good rule of thumb in this environment is that by the time you get FOMO, it's usually too late to catch the wave. Now, if you're lucky enough to get in before that time, just be thankful, but don't fool yourself into thinking that you can do it again.

Likewise, when the market is very affordably priced, like in a downturn, some investors get scared, and they panic-sell because they're afraid of further downside. Many traders say they want to buy on the dips, but then when that dip occurs, they sell instead. Why? Because they're afraid it's going to get a lot worse. Sometimes it does, but usually it doesn't.

During a bull market, less-experienced traders often believe they have a high tolerance for risk, until they encounter a bear market. As you've talked about many times, Mark, the pain of a loss hurts much worse than the joy of a gain. I really don't believe you can truly assess your personal risk tolerance until you've experienced the full bull- and bear-market cycle. And anyone who started investing in April of 2020 or later really hasn't.

MARK: Yeah, that's absolutely true. Even the correction we're in right now is pretty minor compared to some of the longer-term bear markets that we've seen in the past. You'd mentioned earlier "moderation" as being kind of a grand theme, and I think that really ties in nicely with the last item on your list: playing the "all in or all out" game. Why's that a mistake to go all in or all out? And again, how do you prevent that?

RANDY: Yeah, "all in" or "all out"—they are both terrible investing strategies. One statistic that I regularly share at my events is that if you were in the market under only all Republican presidents elected since 1932, your portfolio would have gained 370% in the past 90 years. Not spectacular. Under Democratic presidents, it would have gained 740%. Better, but still not that great in 90 years. But if you had stayed invested 100% during that entire time, you would have gained, get this, 60,000%. That number sounds impossible to some, but it's actually correct, and here's the more amazing thing: That doesn't even include dividends.

Another statistic I like to share is that in the post-WWII era, there have been 12 bull markets. And the average length of those bull markets has been 5 full years, with an average gain of about 166%. In between all of them, there have also been 11 bear markets during that same period. The average length of the bear markets, however, has been only 16 months, and the average loss was about 35%. Now because of how percentages work, that means you'd need a rebound of about 55% to get back to where you started. So basically it's this: Bull markets last about four times longer than bear markets, and their gains are typically about twice as much as how much the bear markets lose. Now, in my mind, that's really all the rationale you need to be a long-term investor. You know, we say this all the time, Mark, time in the market is far more important than timing the market.

MARK: Yeah, and I think as we're recording this is a great example of that because we've got the Russian invasion of Ukraine happening, obviously an enormous humanitarian catastrophe, but it's also causing a lot of volatility in the markets. And volatility is kind of interesting because on the one hand it can be good for traders because it creates opportunities, but on the other hand, what makes it, I think, especially pernicious is that it's hard for us to predict ahead of time how we'll react when volatility strikes. It's easy to say we'll be rational when crunch time hits, but let's face it, it's pretty hard to do that in practice. So what advice do you have for people who think that emotional mistakes—for example, triggered by high volatility—those are really only problems for other people, and yeah, I can see other people having difficulties with that, but that won't happen to me. What do you say to that person?

RANDY: Well, you know, people love to play the blame game, and I would say you can blame anyone you want for anything that happens in the market, but in the end, it's your portfolio, and you're responsible for it. I would just go back to what we discussed earlier. Most people tend to overestimate their risk tolerance. Just because you think you can stomach a 20% drawdown in your portfolio, that doesn't mean you really can, once it actually happens. In a high-volatility environment, such as the one we're currently in, it's extremely difficult to predict the day-to-day movements. And that's not what volatility gauges are intended to do; in fact, it's just the opposite. High volatility means uncertainty is higher, so predicting is harder. Many investors perceive volatility only in a negative fashion. But, in fact, volatility by definition is a measurement of movement, not movement in a particular direction.

When the CBOE Volatility Index, known as the VIX, is around 30, it's implying daily movements in the S&P 500 of about 70 points per day in either direction. That's more than 1.5%. In fact, some of the biggest up days tend to occur during some of the biggest downtrends. Case in point, the S&P 500 is down about 9% year-to-date as we are recording this, yet we've already had 10 days in which the S&P 500 rose by more than 1%.

MARK: All right, Randy, let's talk about some of the cognitive mistakes. And by that I mean mistakes that are made not because of emotion, but because we're genuinely misperceiving a situation. We think something is true and it just isn't. What are some examples of that you see in practice when you are working with investors?

RANDY: Well, here are a couple that come to mind. The first one is failing to properly diversify. While those who actively trade too much of their portfolio, as we talked about earlier, can certainly end up under-diversified, it can actually happen to regular investors—and sometimes unintentionally. There are lots of ways to slice up the market, so it's important to know not only where your individual stocks fall, but also what stocks make up the portfolio of the ETFs or the mutual funds that you own. 

And the second one is trading products or strategies that you don't understand. You know, exchanges and fund companies and others are masters at coming up with creative products and strategies that sound really appealing on the surface, but many of them are filled with disadvantages and unexpected pitfalls.

MARK: Let's talk about each one of those, just like we did with the emotional mistakes, and let's start out with failing to properly diversify. It's interesting you chose that because I'm sure the vast majority of people listening to this have heard that "hey, diversification is a good idea." And yet they don't always actually do it in practice. So tell me, expand on that a little bit and tell me what's going on there.

RANDY: It's an interesting thing that among the five largest companies in the marketplace—Apple, Microsoft, Amazon, Google, and Tesla—only the first two are actually classified as technology stocks, while I've heard many people describe the first four, if not all five, as such. Two other large-cap stocks which are often included in a group of companies known as the FAANG stocks, which was Netflix and Facebook, are also not part of the technology sector.

And yet despite this, I've found that many traders still have way too much exposure to the technology sector, in particular. I don't mean to beat up on this one, but in aggregate, the technology stocks make up about 27% of the weighting in the S&P 500, so owning an ETF that tracks that index already makes you heavily invested in tech stocks. If you own individual shares of Apple and Microsoft, too, it's likely that you're overly concentrated, because at nearly 13% combined, they're by far the two largest stocks in the index. And if you happen to also own an ETF that tracks the NASDAQ, these two stocks alone make up nearly 23% of that one.

Now some people might say that over-exposure in technology stocks is a good thing. After all, the tech sector has been the best performing sector in three out of the last 10 years, and it's been in the top half in seven of the past 10 years. However, the tech sector also has the highest beta among all of the 11 sectors. So while it tends to outperform during market rallies, it also tends to underperform during market downturns. For the 80% or more of your portfolio that make up your core holdings, less volatility is usually more desirable. This doesn't mean that you should substantially reduce your exposure to tech stocks—just make sure that they don't make up like 50% or even more of your portfolio, especially if that's not your plan.

MARK: Yeah, and I think another thing I would add to that is, a lot of statistics you were just mentioning, I bet many people aren't even aware of the fact that they probably have that much exposure to begin with. So they think they're diversified, but they're not nearly as diversified as perhaps they think they are, and that kind of leads to your next point here about trading products or strategies that you don't understand. So again, it seems pretty obvious why that would be a mistake, but it's harder to live up to that in practice than some people might think—is that right?

RANDY: That is right, yes. The financial markets are always rife with new products, new strategies, and new ideas; some good, many not so good.  One such example that comes to my mind in this category is leveraged and inverse ETFs. While these products have been around for well over a decade, many have lost all of their original value completely, and they've had to be fully liquidated. In fact, some of those are doing that right now. Others have lost 99% or more of their value, and yet somehow they still trade actively every day. And while it is possible to profit greatly from one of these if your timing is absolutely perfect, but unfortunately the mathematics of how percentages work and the fact that this leverage resets itself every day makes them really bad long-term investments. After speaking to many traders of these products over the years, I'm convinced that most people who trade them don't really understand how they work.

MARK: Yeah, it's pretty important to read the fine print and make sure you understand how anything you're investing in, how it does in up markets, how it does in down markets, you know, and I think also understand how much you're paying for the product or strategy that you're investing in or at least that you're considering investing in.

RANDY: That's right.

MARK: Let's move on here. Pretty much everything we do with our finances—it's not like we're born with this knowledge. We all had to learn this from somewhere. And yet there is a lot of evidence that we could do a lot better when it comes to learning. What are some of the methods that you use when it comes to learning about a new type of security, a new stock, a new options strategy, or a new trading strategy for that matter?

RANDY: Read, read, read. I know that's boring and dull, but none of this just comes naturally. But I would caution any investor to consider the motivation of the writer. Social media and chatrooms are probably not the best place to go for investment advice. Hedge fund managers and professional investors that come on TV aren't either. Both of them are likely to talk favorably about positions they already own so you'll buy them—or talk down those that they have shorted so you'll sell them.

On the other hand, research and education from firms like Schwab, which don't make markets or hold inventory in stocks, and whose material has to meet rigorous regulatory standards, are a great place to learn; and the vast majority of it is readily available for free. With our published content, our daily live webcasts, and frequent training events, doing your own investing research has never been easier or cheaper than it is now. But at the same time, the quantity of misinformation and bad advice that's available online has also never been greater, so you really have to do be discerning.

MARK: Randy, I want to talk now about just how do we deal with losses? When it comes to investing and trading, there's risk involved. No one goes into a trade or making an investment planning to lose money, and yet to a certain extent it's inevitable when dealing with any particular security. And at least to me, losses are interesting because they have an emotional side to them but also a cognitive side to them. As you mentioned earlier, it hurts a lot to lose money, and that's kind of the emotional side, but if we keep having a series of losses, at some point our brain kicks in, and understandably it's telling us, "Hey, maybe we should do something different because what we're doing isn't working." So how do you decide what to do when you're losing money? How do you balance that emotional side and that cognitive side?

RANDY: Well, I'd say that if your brain tells you to do something different because what we're doing isn't working, you should probably listen. As you said, no one goes into a trade planning to lose money. Unfortunately, it doesn't always work out that way. And while you can theoretically hold a stock forever, that doesn't mean you should.

We've all seen examples where a short-term trade doesn't work out so well, so a trader doubles down and buys more. If a good stock gets drug down by a weak overall market, this can occasionally be a good strategy, but often it isn't. If all the reasons for why that stock was bought in the first place are still valid, buying more can be an effective way to lower the overall cost basis. But if there are valid reasons for the stock drop, don't ignore them; buying more is probably just throwing good money after bad. A good rule of thumb that most experienced traders follow is "If you didn't own it right now, would you buy it?" If not, then it's probably time to sell it and move on.

MARK: Randy, this episode is about learning, learning from our mistakes, and we've all been through some amount of formal schooling, and the report card really is that thing that you get and that helps you gauge whether or not you're learning anything. And when we're investing, our performance track record is kind of like that report card. So I want to wrap up by asking you what's the right way to look at your own performance and learn something from it?

RANDY: As I mentioned earlier, I have a detailed trading log that I have been using for well over 20 years. Like most people, I pay my taxes annually, so I track my investing performance annually, too. That means whether I have a good year or a bad year, it all starts again when the new year arrives.

Not only does my trading log list every trade that I've ever placed, but it also aggregates those trades so I can see how many trades I've made and what my win/loss ratio is. Shockingly, I know, I've need had a year where 90% or even 80% of my trades were profitable. But I've also never had a year in which fewer than 60% of my trades were profitable. If perfection is your goal, then you may as well just give up now.  

Your goal should be to win more on your winning trades than you lose on your losing trades and then watch your portfolio grow over your working life so you can live off of it when you retire.

Look, I mean, some people can go to Las Vegas and hit the jackpot, and some people win the lottery; the reality is most won't. Getting rich quick just isn't a reality for most of us. Investing is not about getting rich quick; it's about getting rich slowly, and that can be a reality for most of us.

MARK: Yep, I think that's exactly right. Randy Frederick is a managing director of trading and derivatives at the Schwab Center for Financial Research. Thanks for being here, Randy. Very helpful.

RANDY: Thanks, Mark. It was great talking with you again.

MARK: Randy gave us a lot of good recommendations. I especially liked his advice to read as much as you can and to keep a trading log. One item I would add, though, is to trust your instincts. If something sounds like it's too good to be true, it usually is. And your instincts can help lead you to gather information from sources you can trust.

But our instincts can also lead us astray, so trust your instincts, but verify their efficacy by comparing them against third-party information. Also, look back at how your instincts have done by using your trading log. Another way of keeping our instincts in check is to use a trading plan. It's often said that markets are governed by fear and greed. A trading plan that uses risk controls and limits how big positions can be is a way of reducing the damage that occurs when we're at emotional extremes.

Finally, never forget one of the questions that Randy posed: "If you didn't already own it right now, would you still buy it?" If not, then it's probably time to sell it and move on.

Schwab has a library of educational webcasts you can use to improve your trading knowledge and help you learn from your trading mistakes. Go to Schwab.com/Live to check those out.

Thanks for listening. If you've enjoyed the show, please leave us a review on Apple Podcasts. And if you know someone who might like the show, please tell them about it and how they can also follow us for free in their favorite podcasting app.

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You can also follow me on Twitter @MarkRiepe. M-A-R-K-R-I-E-P-E.

For important disclosures, see the show notes and Schwab.com/FinancialDecoder.

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