Trading can be an emotional roller coaster. Let us help you gain an understanding of why the psychology of trading is important, and how they can impact trading results positively and negatively.
Psychology has always been an important factor in trading and investing in financial markets. The study and understanding of this aspect of trading have grown tremendously since the turn of the century, with the past 20 years seeing numerous books and courses devoted to the emotions and psychology behind trading behaviour.
Such an important subject demands that any beginning trader gains an understanding of why emotions and psychology are essential, and how they can impact trading results positively and negatively.
Let’s explore the negative “psychological biases” that can trap new and even veteran traders, and consider how to avoid them. We’ll also look at positive steps traders can take to set up a constructive trading environment, with an end goal of increasing longer-term success – and profits.
Rejecting Efficient Market Hypothesis (EMH)
Efficient Market Hypothesis Financial is an economic and investment theory developed in 1965 by Eugene Fama, an American economist. EMH states that asset prices fully reflect all available information. Therefore, risk-adjusted excess returns cannot be achieved.
The implication is that it is difficult to “beat the market” regularly. However, EMH assumes that traders and investors act rationally and consider all available information before making decisions and that they are unbiased in their predictions. These are both WRONG!
No matter how much self-awareness you possess, everyone brings a set of psychological biases to trading. EMH tells us how people should behave, where Behavioural Finance tells us how and why people do behave. It explains how emotions influence our decision-making processes. The reason may be due to herd instincts, or overriding human emotions such as hope, fear, greed, or panic.
Trading requires you to put specific mental processes to work:
- Thought: deciding what you want to do in the market, employing your knowledge and using a trading plan.
- Action: physically entering into the trade.
- Reaction: Your reaction to having a position, which can bring out emotional responses
So financial markets are not directly moved by the news, events, technical analysis, But by the reactions traders have to these events. Emotions can and do impact market price action. And a herd mentality can then create even more volatile market moves.
The brain does not work like a computer. It uses shortcuts, experiences and emotional filters for shortening analysis time. Once focused in one direction, these psychological biases may obscure other, potentially more important, information.
While knowing the common psychological biases may not entirely stop you from making mistakes, it’s possible to identify and name these biases when they appear. This brings the biases from the subconscious into the conscious, where they can be properly identified and catalogued. Over time, this should help make succumbing to biases less frequent.
Hot Hand Bias: This is the irrational view that consecutive winning or losing streaks mean your hand is either ‘hot’ or ‘cold’. The theory is that because a trader may have had profitable trades several times in a row, they believe that the net trade will be profitable also. This is a dangerous bias, which can distort your view of chance. A winning streak can often lead to a more considerable losing trade, because of overconfidence.
Recency Trading Bias: This bias occurs when a trader focuses solely on recent trading decisions and the most recent outcomes, whether they are successful or not. An example would be that a trader could abandon logic and a strong trading strategy because they run on the short-term emotion, which significantly increases the likelihood of a future loss. To overcome recency trading bias, you should approach every trade as a fresh idea, and remind yourself of your of long-term goals.
Bandwagon Effect: This is the cause of many bad investment and trade decisions, and happens when market valuations soar on herd demand at the expense of basic, sensible analysis metrics.
To avoid this bias, you should ensure that trading and investment decisions remain based on reliable fundamental news. In the world of finance, there is never safety in numbers. However, there is no replacement for a strong, tried and tested trading strategy and plan, backed up by independent, objective research
Snake-Bite Effect: This is when a significant loss or series of losses occur and subsequently, the trader fails to follow their trading plan. The fear of losing again makes the trader less inclined to take the risk. This may include refusal or hesitancy to take some trades, despite good set-ups, limiting and reduction of trading position size, and therefore risk. It could also involve trading shorter-term with tighter stops, or exiting trades prematurely. The solution to avoid this is not to abandon the trading plan. You should look to psychologically bounce back after a loss, consider taking a short trading break, or refine (not abandon) the trading strategy or plan.
House-Money Effect: A trader may have a significantly large winning trade- or a series of profitable trades. As the profits are not seen as the trader’s own profits, but rather those of ‘the house,’ this can lead to overconfidence and a move away from the trading plan. That can lead to bigger trades, taking on more risk, or not quantifying risk correctly before trading. To avoid this bias, traders should look to integrate their profits immediately into their own trading account or fund and stick to their trading strategy.