The most troublesome problems we face as traders are the ones that we don't even know exist. Certain human tendencies affect our trading, yet we are often completely unaware they are affecting us and our bottom line. While there are many human tendencies, we will look at three that, if not managed, can block the road toward achieving our financial goals.
Tutorial: Behavioral Finance
The Enemy We Don't Know
When dealing with trading in a technical way, we can see where we erred and attempt to fix it for next time. If we exit a trade too early in a move, we can adjust our exit criteria by looking at a longer time frame or by using a different indicator. However, when we have a solid trading plan and are still losing money, we need to look at ourselves and our own psychology for a solution. (Test your investment strategy before entering the market, but first read Stimulate Your Skills With Simulated Trading.)
When we deal with our own minds, often our objectivity is skewed and, thus, cannot properly fix the problem; the true problem is clouded by biases and superficial trivialities. An example of this is the trader who does not stick to a trading plan, but fails to realize that "not sticking to it" is the problem, so he continually adjusts strategies, believing that is where the fault rests.
Awareness is Power
While there is no magic bullet for overcoming all of our problems or trading struggles, becoming aware of some possible base issues allows us to begin to monitor our thoughts and actions, so that over time we can change our habits. Awareness of potential psychological pitfalls can allow us to change our habits, hopefully creating more profits, let's look at three common psychological quirks that can often cause such problems.
Sensory Derived Bias
We pull information from around us to form an opinion or bias and this allows us to function and learn, in many cases. However, we must realize that, while we may believe we are forming an opinion based on factual evidence, often we are not. If a trader watches the business news each day and forms an opinion that the market is going higher, based on all the available information, he may feel he came to this conclusion by stripping away the media personnel's opinions and only listening to the facts. However, this trader still may face a problem: When the source of our information is biased, our own bias will be affected by that.
Even facts can be presented to give credence to the bias or opinion, but we must remember there is always another side to the story. Furthermore, constant exposure to a single opinion or viewpoint will lead individuals to believe that that is the only practical stance on the subject. Since they are deprived of counter evidence, their opinion will be biased by the available information.
Avoiding the Vague
Also known as fear of the unknown, avoiding what may occur, or what is not totally clear to us, prevents us from doing many things and can keep us locked in an unprofitable state. While it may sound ridiculous to some, traders may actually fear making money. They may not be aware of it consciously, but traders often worry about expanding their comfort zone, or simply fear that their profits will be taken away through taxes. Inevitably, this may lead to self sabotage. Another source of bias may come from trading only in the industry with which one is most familiar, even if that industry has been, and is predicted to continue, declining. The trader is avoiding an outcome because of the uncertainty associated with the investment. (To learn about the home bias, check out Is Biased Investing Holding You Back?)
Another common tendency relates to holding onto the losers too long, while selling the winners too quickly. When prices fluctuate we must factor in the magnitude of the movement, to determine if the change is due to noise or is the result of a fundamental effect. Pulling out of trades too quickly often results from ignoring the trend of the security, as investors adopt a risk-averse mentality. On the other hand, when investors experience a loss, they often become risk seekers, resulting in an over-held losing position. These deviations from rational behavior lead to irrational actions, causing investors to miss out on potential gains, due to psychological biases. (For insight into investors' attitudes, refer to Understanding Investor Behavior.)
Tangibility of Anticipation
Anticipation is a powerful feeling. Anticipation is often associated with an "I want" or "I need" type of mentality. What we anticipate coming is some time in the future, but the feeling of anticipation is here now and it can be an enjoyable emotion. It can be so enjoyable, in fact, that we make feeling anticipation our focus, instead of achieving what it is we are anticipating in the first place. Knowing that a million dollars is going to show up on your doorstep tomorrow would create a fantastic feeling of excitement and anticipation. It is possible to become "addicted" to this feeling and thus put off taking payment.
While easy money delivered to the door is more than likely to be grabbed by the eager homeowner, when things are not quite as easy to come by, we can fall into using the feeling of anticipation as a consolation prize. Watching billions of dollars change hands each day, but not having the confidence to follow a plan and take a chunk of the money, can mean we subconsciously decided that dreaming about the profits is good enough. We want to be profitable, but "wanting" has become our goal, not profitability.
What to Do About It
Once we are aware that we may be affected by our own psychology, we realize it may affect our trading on a subconscious level. Awareness is often enough to inspire change, if we do in fact work to improve our trading.
There are several things we can do to overcome our psychological roadblocks, beginning with removing inputs that are obviously biased. Charts don't lie, but our perceptions of them may. We stand the best chance of success if we remain objective and focus on simple strategies that extract profits from price movements. Many great traders avoid the opinions of others, when it comes to the markets, and realize when an opinion may be affecting their trading.
Knowing how the markets operate and move will help us overcome our fear, or greed, while in trades. When we feel we have entered unknown territory where we don't know the outcome, we make mistakes. However, if we have a firm understanding, at least probabilistically, of how the markets move, we can base our actions on objective decision making.
Finally, we need to lay out what we really want, why we want it and how we are going to get there. Listen in on the thoughts that run through your head right when you make a mistake, and think about the belief behind it; then work to change that belief in your everyday life.
The Bottom Line
Our biases can affect our trading, even when we don't think we are trading on biased information. Also, when an outcome appears vague, we err in our judgment, even though we have a conception of how the market is supposed to move. Our anticipations can also be deterrents from achieving what it is we think we want. To aid us in these potential problems, we can remove biased inputs, gain more understanding of market probabilities and define what it is we really want from our trading. (To learn how to quantify and manage the underlying risk of investing, read Measuring and Managing Investment Risk.)