An investor can start with practically nothing, buying a few thousand dollars worth of shares. If he buys and holds, his commissions and other expenses will be minor factors in his success or failure. Traders have a harder task. Seemingly trivial expenses can break them, and the smaller the account, the greater the danger. Transaction costs can raise an impassable barrier to winning. Transaction costs?! Beginners hardly think of them, yet transaction costs are a leading cause of trader mortality. Adjusting your plans to reduce those costs gives you an advantage over the market crowd. I have a friend whose 12-year-old daughter recently came up with a brilliant idea for a new business, which she called The Guinea Pig Factory. She ran off promotional flyers on her mom’s copy machine and stuffed them into neighbors’ mailboxes. Guinea pigs, popular among kids in her neighborhood, cost $6, but she could buy them at the central market for only $4. The girl dreamed of profits when her mother, who is a trader, asked how she was going to get from the Sydney suburb where they lived to the central market and back. Someone will give me a ride, answered the girl. A child may get a free ride, but the market will not give it to you. If you buy a stock at $4 and sell it at $6, you won’t make a $2 profit. A big chunk of it will go for transaction costs. Amateurs tend to ignore them, while professionals focus on them and do everything in their power to reduce them—unless they’re collecting them from you, in which case they try to blow them up. Beginners get into their Guinea Pig Factories and cannot understand why they keep buying at 4, selling at 6, and are still losing money. A new trader is like a little lamb walking into a dark forest. He is likely to be killed, and his skin—his trading capital—divided three ways, between brokers, professional traders, and service providers. Each will try to grab a piece of that poor lamb’s skin. Don’t be that lamb—think of transaction costs. There are three kinds of them: commissions, slippage, and expenses.

Traders make money by betting on short-term price swings. The idea is to buy when our reading of the market tells us prices are rising and sell when the uptrend runs out of steam. Alternatively, we can bet on a decline and sell short when our analysis points to a downtrend, covering when the downtrend starts bottoming out. The concept is simple, but implementing it is difficult. It is hard to become a good analyst, but harder to become a good trader. Beginners often assume they can make money because they’re smart, computer-literate and have a record of success in business. You can get a fast computer and even buy a backtested system from a vendor, but putting money on it is like trying to sit on a three-legged stool with two legs missing. The two other factors are psychology and money management. Balancing your mind is just as important as analyzing markets. Your personality influences your perceptions, making it a key aspect of your success or failure. Managing money in your trading account is essential for surviving the inevitable drawdowns and prospering in the long run. Psychology, market analysis, and money management—you have to master all three to become a success. There are two main approaches to profiting from crowd behavior. The first is momentum trading—buy when a ripple starts running through the crowd, sending the market higher, and sell when that ripple starts losing speed. It is a challenge to identify a new trend while it’s still young. As the trend speeds up and the crowd becomes exuberant, amateurs fall in love with their positions. Professionals remain calm and monitor the trend’s speed. As soon as they find that the crowd is returning to its normal sleepiness, they take profits without waiting for a reversal. The other method is the countertrend strategy. It involves betting against the deviations and for a return to normalcy. Countertrend traders sell short when an upside breakout starts running out of speed and cover when a downtrend starts petering out. Beginners love to trade against trends (“let’s buy, this market can’t go any lower!”), but most get impaled on a price spike that fails to reverse. A man who likes peeing against the wind has no right to complain about his cleaning bills. Professionals can trade against trends only because they are ready to run at the first sign of trouble. Before you bet on a reversal, be sure your exit strategy and money management are fine-tuned. Momentum traders and countertrend traders capitalize on two opposite aspects of crowd behavior. Before you put on a trade, be sure to know whether you’re investing, momentum trading, or countertrend trading. Once you’ve entered a trade, manage it as planned! Don’t change your tactics in the midst of a trade because then you’ll contribute to the winners’ welfare fund. Amateurs keep thinking what trades to get into, while professionals spend just as much time figuring out their exits. They also focus on money management, calculating what size positions they can afford under current market conditions, whether to pyramid, when to take partial profits, and so on. They also spend a great deal of time keeping good records of their trades.

Just as economies of scale and specialization create profit opportunities for financial intermediaries, so too do these economies create niches for firms that perform specialized services for businesses. We said before that firms raise much of their capital by selling securities such as stocks and bonds to the public. Because these firms do not do so frequently, however, investment banking firms that specialize in such activities are able to offer their services at a cost below that of running an in-house security issuance division. Investment bankers such as Merrill Lynch, Salomon Smith Barney, or Goldman, Sachs advise the issuing firm on the prices it can charge for the securities issued, market conditions, appropriate interest rates, and so forth. Ultimately, the investment banking firm handles the marketing of the security issue to the public. Investment bankers can provide more than just expertise to security issuers. Because investment bankers are constantly in the market, assisting one firm or another to issue securities, the public knows that it is in the banker’s interest to protect and maintain its reputation for honesty. The investment banker will suffer along with investors if it turns out that securities it has underwritten have been marketed to the public with overly optimistic or exaggerated claims, for the public will not be so trusting the next time that investment banker participates in a security sale. The investment banker’s effectiveness and ability to command future business thus depends on the reputation it has established over time. Obviously, the economic incentives to maintain a trustworthy reputation are not nearly as strong for firms that plan to go to the securities markets only once or very infrequently. Therefore, investment bankers can provide a certification role—a “seal of approval”.