Have you experienced any of these situations:
- A stock is on a tear – it goes straight up every day. You feel like you’re the only one missing the trade. You must jump in. You buy at the high and watch the in stock immediately pull back 10%.
- You own a stock that’s on a good run. Suddenly, the stock pulls back 10%. You panic, get out (at the bottom), only to see the stock rise 30%.
- You research, research, and research a stock. All the experts say it’ a great investment. You make the investment and the stock trades off day after day after day. You continue to hold, and it continues to trade off. You ride it all the down (even when negative news comes out) for a major loss.
- How many times have you said “I’ll never trade that strategy again” or “I’m going to trade smaller, more in proportion to my account size” only to change back to your old habits a week or two later?
It’s our emotions and the way in which we process and analyze information that are driving these decisions. Research in Behavioral Finance can help us better understand some of the roadblocks we may encounter to a successful trading career and provides some tools used to overcome these challenges.
What is Behavioral Finance?
Behavioral Finance is the study of how we behave and make financial decisions. It researches how psychology and biases influence our financial behavior. Think of it as “psychology for traders and investors”. Research has shown that our trading and investing success (or lack of success) is based on how well we manage our emotional biases and the cognitive errors we can make in processing and analyzing information. Contrast this with traditional finance theory which focuses on how traders and investors “should” behave and assumes we always act in a rational, risk averse, wealth maximizing way. Let’s explore a few of the more common emotional biases and cognitive errors that challenge each of us and what we can do about them.
How Do Emotional Biases Impact Trading and Investing?
Emotional biases stem from emotions, feelings, beliefs and perceptions, not conscious thoughts. They can cause us to make less than optimal decisions. Here are a few of the major emotional biases:
- Loss Aversion: Our losers bring greater pain than our gains bring joy. Consequently, we hold on to losers too long so we don’t have to recognize the loss and feel that pain (the stock will come back!) and sell winners way too quickly for fear the gain will reverse.
- Over Confidence: You’re on a winning streak, you feel you can do no wrong, you start to trade in larger size, take riskier trades, you’re not appropriately hedged, you brag to your friends that you’ve “figured it out” and then you have string of large losses.
- Regret Aversion: You avoid making decisions or taking actions because you want to avoid the pain associated with making bad decisions. You don’t sell a loser because you don’t want to look back and regret that decision if the stock rallies. You don’t take a trade even though it has a great setup because you’re afraid to have another loss. You take trades that everyone else is taking because “there’s safety in numbers” (also called Herding Behavior).
How To Over Come Emotional Biases
Unfortunately, there’s no silver bullet, we are emotional creatures. But there are a few steps you can take to reduce the impact of these biases on your trading. First, recognize when these biases are present and are driving your trading decisions. Second, develop detailed trade setups that will guide your opportunity selection. Third, have a well-documented trade strategy that details exactly the steps you’ll take at each point in the trade. You’ve mapped out your actions before entering the trade, so when a situation arises, emotions don’t take over, you just follow your plan. Fourth, analyze your trade results over long periods of time to look for the patterns in profitable and unprofitable decisions. Based on this analysis, write down your “I wills” and I won’ts”. Fifth, analyze the trades you didn’t take and see what you can learn.
How Do Cognitive Errors Impact Trading and Investing
Cognitive errors result from faulty reasoning. We process or analyze information incorrectly, our memories are flawed, we don’t (or can’t) consider all the information available or we use rules of thumb to simplify the decision-making process. Here are a few of the major cognitive errors:
- Confirmation: Have you ever had a trade go against you and then scour the internet looking for information or opinions that support your trade and try to shut out the noise of the those on the other side of the trade? That’s confirmation bias – looking for information that supports your view and discounting or ignoring opposing views.
- Conservatism: You do all your homework to develop an opinion for a trade. But then new information comes out and you fail to take it into account, especially if it would change your view and you’d have to admit that you might be wrong. Or maybe you don’t ignore new information, but just delay incorporating it into your view.
- Framing: Ever blindly follow a trade that a “TV guru” said is a fist pounding, guaranteed winner without doing your own research? Framing errors occur when actions are taken based on how information is presented and by whom rather than the content of the information.
How to Overcome Cognitive Errors
All the Emotional Biases considerations detailed above apply here. Also:
- Actively seek out information that is specifically contrary to your view and incorporate into your analysis. In fact, incorporate any new information (positive or negative) into your view immediately.
- Don’t take short cuts; complete your analysis and follow your setups before entering a trade.
- Keep learning, analyzing, and updating your approach. As we say at Masters In Trading: “Education mitigates risk!”
Take Behavioral Finance Concepts Into Account
Next time you have an urge to make an emotional trading decision, take a step back, consider what’s driving those emotions and make sure you have the above suggestions in place. As always, paper trade more than you think you should. The confidence and processes you develop through successful paper trading will help you manage your emotions to success!
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