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.