Trading psychology refers to the emotions and mental states that help determine success or failure in trading securities. Trading psychology represents the various aspects of a person’s character and behavior that influence their trading actions and can be as important as other attributes, such as knowledge, experience and skills in determining trading success.
Discipline and risk taking are two of the most critical aspects of trading psychology as the implementation of these aspects by traders is critical to the success of their trading plan. While fear and greed are commonly associated with trading psychology, things like hope and regret also play a role in trading behavior.
Understanding Trading Psychology
Trading psychology can relate to certain emotions and behaviors that are often the catalyst for market trading. Traditional characteristics of emotional behavior in markets attribute most emotional trading to either greed or fear.
Greed can be thought of as an excessive desire for wealth, so intense that it sometimes clouds rationality and judgment. Greed can lead traders to a variety of suboptimal behaviors. This may include making high-risk trades, buying shares of an untested company, or buying shares because the technology is rapidly increasing in cost, or without researching the underlying investment.
Additionally, greed can motivate investors to stay in profitable trades longer than is advisable by squeezing additional profits or taking large speculative positions. Greed is most evident in the final stages of a bull market when speculation runs rampant and investors become cautious.
Conversely, fear causes traders to close positions prematurely or avoid taking risks due to concerns about significant losses. Fear is evident in bear markets and is a strong emotion that can cause traders and investors to act irrationally in their haste to exit the market. Fear often turns into panic, which usually results in a significant selloff in the market from panic selling.
Regret can allow a trader to enter a trade after initially missing it because the stock moved too fast. This is a violation of trading discipline and often results in direct losses from security prices falling from highs.
Why Trading Psychology Matters
The performance of a trader’s portfolio is related to investment decisions, which are influenced by the trader’s emotions, subjective tendencies and mental processes. Investment decisions can be made through the use of fundamental analysis, using data from a company’s financial statements and regulatory filings along with data on financial conditions. Alternatively, technical analysis can be used to make decisions using historical market price and volume data. Regardless of the type of data used, biases (personal biases), and heuristics (unconscious mental shortcuts and patterns), can influence an individual’s collection and interpretation of data. This can affect decision making and result in judgment errors, potentially leading to suboptimal portfolio performance.
What is Behavioral Finance?
Part of trading psychology is understanding why people make irrational decisions in the market or other money matters. Behavioral finance is a subfield of behavioral economics that identifies the psychological influences and biases that influence the financial behavior of traders and financial professionals. Psychological effects and biases can help explain all kinds of market anomalies, including sharp rises or falls in securities prices.
The Efficient Market Hypothesis previously assumed that market participants were rational and that markets were efficient, however, behavioral finance challenged this assumption. It acknowledges that market participants may be prone to biases and heuristics, which affect rational decision-making. Behavioral finance therefore seeks to understand why people make investment decisions and how these decisions affect financial markets.
Behavioral Biases in Investing
Behavioral finance generally includes the concept of behavioral biases, some of which are described below:
Mental Accounting
ย Mental accounting is the tendency of individuals to deal with different amounts of money by allocating them into mental categories or “buckets” instead of treating all money as interchangeable. One example, related to loss aversion (addressed later in this article), is the tendency of investors to sell winning stock positions rather than losing stock positions.
Selling at a loss may be a more rational decision because of the tax-loss benefits and the fact that a loss investment is likely to be a weak investment. However, this decision can be made based on the psychological categorization of investors to distinguish winners from losers and aversion to incurring losses.
Overconfidence
Overconfidence is the tendency to overestimate one’s abilities, skills and knowledge. Many investors consider themselves to be more skilled at investing than other market participants. However, being above average is statistically impossible for most investors. Overconfident investors tend to overtrade, resulting in high transaction costs and poor performance. Studies have also shown that overconfident investors tend to overestimate their own predictive abilities and the accuracy of data, resulting in an emotional charge and higher risk taking.
Herd Behavior:
Herd behavior states that people tend to mimic the economic behavior of the majority herd. The natural human desire to feel part of the crowd sometimes influences investors to follow the investment actions of others. When the crowd is normally moving in one direction, a person may find it uncomfortable or wrong to go in the opposite direction.
Therefore, investors may follow the crowd by buying the assets the crowd is buying, neglecting to do their own research and assuming that others have done the research. Herding is notorious in the stock market as the reason behind dramatic rallies and sell-offs. A recent example of this was the dotcom bubble, in which investors chased the crowd, buying securities in many Internet-based businesses in anticipation of future profits that never materialized, resulting in a sharp selloff.
Emotional distance
Emotional distance is making decisions based on strong emotions or emotional stress such as anxiety, anger, fear or excitement. Emotions are the main reason people make irrational choices. As mentioned earlier, fear and greed are key drivers of human behavior, which can lead to overreactions, leading to unfounded optimism, irrational exuberance and asset bubbles or, conversely, market panic and massive sell-offs.
Self-attribution:
Self-attribution is the tendency to attribute success to one’s own personal abilities, while attributing failure to external factors. Self-attribution usually stems from internal expertise in a particular field. In this category, individuals rank their knowledge higher than others, even if it objectively falls short. Thus, an investor may attribute successful investment performance to their own superior judgment skills but attribute poor performance to bad luck rather than poor decision making.
What are the main categories of behavioral biases that traders face?
Traders typically encounter two categories of behavioral biases: cognitive biases and affective biases. Cognitive biases are patterns of errors or blind spots in thinking that are common to humans, resulting from subconscious mental processes.These may also consist of overconfidence bias, intellectual accounting, and anchoring bias, amongst different examples.
Emotional biases are deviations from rationality caused by emotions, moods, perceptions, or beliefs. These include herding behavior, loss avoidance bias, and the emotional influences of fear and greed. Both categories of bias can lead to irrational judgments and errors in decision making.
How can traders overcome biases to avoid losses?
To overcome biases, traders can use several strategies. Improving education of behavioral finance principles can increase self-awareness and improve decision-making.Developing and sticking to a buying and selling plan with buying and selling guidelines and threat managementpractices can provide a structured approach to investing, reducing room for emotional decisions.
Conducting their own objective fundamental or technical analysis research on investment opportunities and finding a range of data to support the analysis, including contrasting perspectives, can help avoid herd-following behavior and challenge existing beliefs.
Note:
Trading psychology influences the state of mind of investors and is as important as knowledge and skill in determining trading success. Biases or subjective biases, heuristics or unconscious mental patterns, and emotions such as fear and greed are strong drivers of traders’ decision-making and therefore trading performance. Behavioral finance is about making financial decisions and understanding how these affect financial markets. Some common behavioral biases include mental accounting, overconfidence, herd behavior, emotional distancing, anchoring, self-attribution, and loss aversion. Understanding these and other behavioral concepts can help improve decision making and trading results.
FAQs
Is trading psychology only for professional traders?
No, trading psychology is relevant for traders of all levels, from beginners to experienced professionals. It impacts decision-making in financial markets.
How can I overcome fear and greed in trading?
Overcoming fear and greed involves self-awareness, establishing clear trading rules, and practicing discipline in decision-making.
What are some common cognitive biases in trading?
Confirmation bias, anchoring, and overconfidence are common cognitive biases that can impact trading decisions.
Is it essential to have a trading plan?
Yes, having a well-defined trading plan is crucial for maintaining discipline and making informed decisions in the market.
How do successful traders handle losses?
Successful traders view losses as learning opportunities and focus on continuous improvement rather than dwelling on setbacks.
