Everything from casinos to supermarkets are designed to encourage us to think in a particular way or buy a certain item. It’s no secret, but even knowing this doesn’t make us immune to it.
This is also true when it comes to the psychology of investors and investments. A quick search on Amazon or Google will bring up hundreds of articles and books about the psychology of investing. For those who make a living investing and trading, it’s a way to understand their own psyche and how they can best use this understanding to be financially successful.
It’s all too easy to believe the stereotypes you are presented with on film and TV. Here, traders are usually always male, ambitious, driven, egocentric and a moral compass pointing directly at ‘sociopath’. Though some aspects of this stereotypical trader do ring true, the industry isn’t just filled with Gordon Gecko or Jordan Belfort types.
For those people curious about getting into trading and wanting an insight into how psychology plays an important role.
Psychology of trades
Before diving into the exciting world of trading and investments, it’s a good idea to learn and recognize the psychological pitfalls behind your trades. Many platform demo accounts let you test your skill and put your newfound knowledge to the test before your start risking your own money.
Trade Psychology #1 - Information Exposure Bias
This type of trade is made based on information you are exposed to most often without checking the accuracy of the information.
How to avoid it: Vet all information you receive and get confirmation from as many sources as possible. Don’t latch on to self proclaimed gurus.
Trade Psychology #2 - Information Confirmation Bias
This type of bias occurs frequently without us even realising it. In everyday life, it tends to take the form of forming an opinion of someone and then seeking a way to twist the facts or disregard them in order to support that opinion. We often do this with politicians and celebrities.
Trading based on your biases is dangerous as you are not developing the skills of research and objective reasoning. If your trade comes off, then it only confirms your bias (even if it was luck).
How to avoid it:Much like information exposure bias, you need to ensure that you aren’t acting on a hunch or a preconceived idea about something. Check all information for accuracy and try to look at it objectively.
Trade Psychology #3 - Being Overconfident
There’s a fine line between confidence and overconfidence. Confidence is essential but overconfidence can cost you a lot of money.
Relying on your ‘gut’ rather than other information is a sure way to lose money. Going all in on a loser is bad enough, but then trying to chase a loss or hold on to trades for longer than they should.
A few big wins might begin to give you the feeling they are invincible, but remember to temper your enthusiasm with a good research backed strategy.
How to avoid it: Learn to admit that you can be wrong. Keep yourself open to embracing new opinions and information and the fact that someone might know more than you. Try and take your ego out of the equation and use a system to dictate when to get in and out of trades.
Trade Psychology #4 - Trend Trading
We’re always hearing about investors who got in early on opportunities such as Netflix, Uber, or other skyrocketing companies. Many inexperienced investors see that a stock is doing well and assume that it will continue to do so in the future. Stock prices don’t tend to increase exponentially upwards, and those who do make the money from it have usually been tracking the market for a long time and got in early. Don’t go chasing high returns when the company is starting to plateau off.
How to avoid it: Chasing a unicorn is likely to end up in disappointment. Set your own set of criteria for when to get into a trade and when to exit it. Don’t waver from this.
Trade Psychology #5 - Too Much Choice
New investors can be overwhelmed by the choice. It is almost impossible to keep up with all sectors and markets. It can cause you to miss opportunities and make mistakes. Alternatively, you can be paralysed with too much information and be too scared to make a trade, worrying that you're going to miss something.
How to avoid it: Choose only a few sectors or companies to concentrate on at one time.
Trade Psychology #6 - Risk Aversion
Being too risk averse doesn’t go hand in hand with successful trading and investments. Investors who are too cautious can miss out on great opportunities or cannot cut their losses by hanging onto bad stocks.
How to avoid it: set limits of risk on every trade. Once an opportunity exceeds that limit, leave it.
How to use psychology to your advantage
In addition to learning the ins and outs of trading, learning the psychology and mindset behind them is just as important. By recognising the emotional driving forces behind your actions, you can start to devise systems to start removing emotion from your decision making. The best traders don’t just operate by their ‘gut feeling’, they base their decisions on the available information and learn how to use this information to make educated predictions. This makes their gut feeling more likely to be right as they are based (whether they realise it or not) on their prior experiences.
Be open to changing your mind when new data is presented and always be willing to admit when you are wrong and cut your losses early, rather than trying to chase a win.
This is a contributed post.
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