Why people lose money in the stock market?

By John Hwang

The reasons for losses are simple. In fact, there are only two root causes for investing losses:

  • Over estimation of one’s ability to invest
  • Letting emotions, not processes, guide decisions.

These two reasons account for over-trading and loss aversion, which cause most of the damage for investors.

#1: Over estimation of one’s abilities

There’s a well documented cognitive bias called Dunning–Kruger effect which states that novices tend to be overly confident of their abilities.

This causes vicious cycles in investing, leading to losses. Here’s how.

A novice investor opens a stock account, believing that he or she can time the market consistently due to over-confidence.
This bias toward market timing leads to over-trading, i.e. making more than the necessary number of trades.
This leads to an unnecessary piling of trade commissions, as well as wasted time and effort staring at markets
This piling of transaction costs naturally causes a negative drift in the account.

Thus, if you take two average joes who start investing, the over-confident one will more likely lose money than the conservative one due to transaction costs.

And given the Dunning-Kruger effect, more often than not, most new entrants are over confident, and incur unnecessary losses due to transaction costs.

This has been going on for multiple decades as brokerages have made it their bread and butter to encourage trading.

#2: Letting emotions, not processes, guide decisions.

It has been well documented that investors tend to sell the low, buy the high, i.e. momentum chasers (in a negative sense).

One way to see that is to look at the net retail investors flows in/out of domestic equity funds.

As you can see, retail investors pulled out a record amount out of the markets in 2008 (at the peak of the crash), and put in the record amount in 2007 (right before the crash).

* The size of the red bar indicates the domestic in/out flow. Red is retail flow.

So basically, most retail investors get greedy and panic at inopportune times.

This is due to the basic fear/greed mechanism.

People (professionals included) tend to over-project their optimism when things are good.

And people tend to get depressed, bipolar when things hit the fan, leading to irrational actions.

And they let their emotional state project itself onto their investing decisions (as we see in the chart), leading to missteps.