Jonathan Davis: Brutal truths of day trading

What makes a good trader in shares? The question has long been a source of fascination, not just to me, but to hundreds of thousands of others, who down the years have found themselves attracted and then ensnared by the "come-hither" charms of the stock market. Its promise of large and unbounded financial gains are so easy to observe and envy, but so maddeningly hard to sustain over any long period when you try to do it yourself through active trading.

What makes a good trader in shares? The question has long been a source of fascination, not just to me, but to hundreds of thousands of others, who down the years have found themselves attracted and then ensnared by the "come-hither" charms of the stock market. Its promise of large and unbounded financial gains are so easy to observe and envy, but so maddeningly hard to sustain over any long period when you try to do it yourself through active trading.

So engrossed are most newcomers to the market with the scale of the potential rewards on offer, that they fail to notice that most of the professionals who work in the City don't actually get paid for their expertise in obtaining exceptional returns from the market. Instead, they are rewarded very handsomely for their skill in laying claim to part of the returns other investors earn, whether that reward comes as stockbroking commissions, fund management fees, the cost of advice, or some other form of monetary reward.

Just as it makes more sense, given the choice and the nature of the game, to be a bookie rather than a punter, so it makes most sense, if you know anything about the way markets work, to sell your expertise to others rather than rely on it to make a living purely on your own account. The former is a relatively certain and socially acceptable path to continued financial well-being. The latter, which is what trading is ultimately about, is inherently risky and, in practice, extraordinarily difficult to make work. Yet the lure of trading as a source of income remains a powerful and dangerous siren call that a number of otherwise sensible people have fallen prey to in the last couple of years. The hardest thing of all to take, which any poker player could tell you, but most first-time traders choose to ignore, is that, given the way that any game of probability works, you can still go out of business even if your method of picking winners is a successful one. The reason is that you need a significant amount of working capital not just to play the game, but to see you through the losing periods you are bound to endure, even if your long-term track record at picking winners is exceptionally good. Most of the world's poker champions have gone bust at one time or another for just this very reason.

If you need proof of these various truths, I fear you need look no further than the example of the articulate and otherwise apparently sensible middle-aged fellow, who for the past year has been keeping readers of a broadsheet Sunday newspaper updated with a weekly account of his efforts to become a full-time day trader. This hapless but rather endearing bozo (I don't wish to be unkind, but I cannot think of a better epithet) persuaded his wife a year or so ago to sell their house so he could start full-time day trading with the capital. Now, after a year of anxiety and persistent failure, he has finally, it appears, realised the instant riches he thought awaited him are not now going to materialise. Forty-nine weeks from the day he started on this madcap endeavour, which was prompted by the apparently easy money to be made from buying and selling technology stocks, he has now lost a grand total of £29,800 from his trading activities.

To this, of course, should be added the income he has foregone by giving up his full-time job to start his career as a trader, and the less easily measured other costs that trying and failing to become a "market wizard" has imposed on him and his family. "I would never have believed the stress and strain this constant pressure can exert," he said last weekend, adding that he is thinking about throwing in the towel.

The fact that he has failed should come as no surprise, since he set out with insufficient funds, no discernible trading strategy, no insights of value about the way markets work and a touching but unfounded faith in his ability to outsmart the rest of the market. Engineers and other professionals are particularly prone to believe any activity can be mastered, given sufficient effort and application, but making money from financial markets requires more than just application and logic.

It is a pity that he did not take time to read one of Jack D Schwager's books before he set out on his great adventure. Schwager has published three books which describe, through on-the-record interviews, how the most successful traders in the United States, all professionals, have made their money. The titles, Market Wizards, New Market Wizards and the latest, Stock Market Wizards, are entertaining and instructive reads for anyone tempted to think about doing their own trading.

My test of a good investment book is one I am prompted to underscore in a lot of places, and my copies of all three of Schwager's books bear evidence of serious vandalism. The message in all of them is that you need certain qualities to be a success as a stock-market trader. You need a trading method, though the strategy of that is not as important as the discipline with which you apply it.

You need a method for controlling your losses on bets that go wrong, because money management is just as important as picking winners. You must have the ability to admit you have been wrong, and to turn mental somersaults without breaking sweat. (Benjamin Franklin: "One of the greatest tragedies of life is the murder of a beautiful theory by a gang of brutal facts.") Rather than rely on anybody's else ideas or opinions, such as broker's research, you should stick to your own and ruthlessly monitor your successes and failures. You should avoid any method that relies on forecasting, which is unreliable and risky. Most of all, you need to be obsessive, and maintain iron control over your emotions, sustaining confidence in your abilities even when everything is going badly.

Most online traders fail to pass most of these tests. They are amateurs who have been drawn in for the worst possible reason - the fact that, as with the bubble in technology stocks, the market suddenly appears to offer easy pickings. As Warren Buffett puts it in his latest annual report to shareholders, mailed at the weekend: "A pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons. First, many in Wall Street - a community in which quality control is not prized - will sell investors anything they will buy [London is no different]. Second, speculation is most dangerous when it looks easiest."

The irony is that now that speculation no longer looks so easy, few are queuing to try their luck. It is unkind but true to point out that if The Sunday Times day trader, instead of putting all his money not in fast-moving technology shares and what seems to be his Great Expectation, a speculative mining and exploration stock called Pan Andean Resources, he had put the lot into an unloved and beaten-up old economy stock such as BATs (paying a dividend of 7 per cent at the time, and doubled in value since he started a year ago), he could have spent the whole of the past year stress-free on the golf course. It surely is a tough old world.

davisbiz@aol.com