You might have heard or read that trading is all about keeping control of your emotions. This is completely true and while you have to keep your emotions at bay, you can also take advantage of the emotional traits and behavior of other traders.
Emotions are not like an item you can simply put away. It is difficult to be rational all the time and that’s why there are so many studies on the aspects of investor psychology.
Sometimes, an investor’s lack of emotional control and lack of ability to manage the pressure of a decision can be expressed as a strange behavior (even when they feel they’re in complete control).
This occurs very often because economics and finances are somewhat seen and treated as if every individual was completely rational. However, psychology and emotions play an important role in investing.
Only understanding the trading psychology you WILL become a better trader.
Many times “Intelligent trading” is described as a trait of the character rather than the brain. Other people state that emotional makeup is more important than intellectual ability for success.
Whatever example you think suits you best, always keep in mind that emotional control is a key factor to successful trading.
The Trader Psychology
Everyone has overestimated themselves at one point or another. Generally speaking (and this is a fact) people tend to rate one’s abilities as above the average.
This might be a good trait in some occasions, but when it comes to trading, it can do more harm than good. In most cases, overconfidence can result in making some bad decisions even when the market is showing proof of what you should be really doing.
This exaggerated type of confidence usually leads to overtrading by substituting knowledge and facts for the sense of being in complete control.
Remember to always keep track of the facts and reliable information and act based on that. If at some point you’re feeling very confident as if you would not be able to make a mistake, then you’re probably about to make one.
A serious threat for investors, it is so easy to fall on this mistake that sometimes, even the most experienced investors fall for this mistake. As the name implies, this is caused by regret. The regret of having made a bad decision, the regret of facing the consequences of a mistake.
A good example of how it works would be to imagine purchasing a certain stock at $200. At the time you thought it was a bargain and you seriously believe that you’ll get at least a decent return. Time goes on and prices keep going down until you’re inevitably facing the truth. It was a bad investment.
Now, when you’re faced with the decision of selling the stock regret comes into play. It is at this moment when this emotion can blind you, and traders who fall victim of this fail to accept that they were wrong and might even refuse to sell the stock.
To avoid this from happening, the best thing you can do is put yourself a limit or use tools such as stop-loss orders. This way you can make sure that under a certain amount you’ll sell instead of doubting and suffering greater losses in the future.
Herding is the natural behavior of most living beings. The act of following a group or a crowd is basically what makes us a society and from the evolutionary point of view it has served us to evolve. However, in the financial world, this behavior can be detrimental for your trading operations.
Investor’s herd behavior or mentality is a psychological way of reducing the perceived risk of a decision by using it as an excuse. Sometimes, it is not about reducing that perceived risk but a way to manage feelings such as the investor’s regret.
This behavior is pretty common among the less experienced individuals and can be observed in certain situations such as when the Bitcoin price went all the way up to $20,000. Many of the investors did not even know what Bitcoin was, but as the price kept rising and the event made the news, investors with the herd mentality ended up buying it at its highest price.
The biggest problem with this is not following the crowd itself, but making the mistake of using that as an excuse and as a way to blame other people instead of facing the mistake. “Everyone did it so I did, at least I am not the only one losing” can be a great example
This is a habit that every trader must get rid of. This pattern of behavior is usually repeated again and again, but it is completely profit-limiting and mostly useless.
The Prospect Theory
The less risk you can take for the greatest amount of investment return sounds excellent. In fact that is what everyone wants, less risk but greater returns. However, it is very interesting to notice that aversion to loss is a stronger emotion than that happiness of gaining something.
This loss aversion is extremely common and powerful, and drives investors to hold on to a stock when they shouldn’t. Nobody wants to lose and that means that you’re probably going to take a greater risk to avoid losses.
Think about it. If you lose $10,000 on a trade your feelings are going to be much, much stronger than if you earn that same amount. It is something like gambling. When the gambler wins he might feel a certain degree of satisfaction, but when he loses, he can become more aggressive in the hopes of getting that money back.
This can also explain why an incredible amount of traders tend to sell their winners but hold on to their losers. Although these variable degrees of emotions towards gains and losses will always be a part of every one of us, mistakes can be prevented by just being aware of it.
Conclusions on Trader Psychology
Emotions can’t just disappear, however, every trader that wants to succeed must learn how to keep them in control (which is a more realistic goal).
These 3 behaviors are one of the most common and known behaviors in the trading world. Some of these will lead to other behaviors such as biases in which the trader attributes their winnings to their ability but blame their losses to external factors.
Some traders can lose thousands and thousands of dollars until realizing that their lack of control is keeping them from becoming better.
It is not something you should feel afraid of but put attention to. Once you understand why you or others behave in a certain way, you are ready to take your trades to the next level and gain a significant advantage.