What is Trading Psychology?
Trading psychology refers to the emotions and mental state that help dictate success or failure in trading securities. Trading psychology represents various aspects of an individual’s character and behaviors that influence their trading actions. Trading psychology can be as important as other attributes such as knowledge, experience, and skill in determining trading success.
Discipline and risk-taking are two of the most critical aspects of trading psychology since a trader’s implementation of these aspects is critical to the success of his or her trading plan. Fear and greed are commonly associated with trading psychology, while things like hope and regret also play roles in trading behavior.
- Trading psychology is the emotional component of an investor's decision-making process which may help explain why some decisions appear more rational than others.
- Trading psychology is characterized primarily as the influence of both greed and fear.
- Greed drives decisions that appear to be too risky.
- Fear drives decisions that appear to avoid risk and generate little return.
- Behavioral finance has documented several psychological biases and errors involved when making trading or investment decisions.
Understanding Trading Psychology
Trading psychology can be associated with a few specific emotions and behaviors that are often catalysts for market trading. Conventional characterizations of emotionally-driven behavior in markets ascribe most emotional trading to either greed or fear.
Greed can be thought of as an excessive desire for wealth, so excessive that it clouds rationality and judgment at times. Thus, this characterization of the greed-inspired investor or irrational trading assumes that the greed emotion can lead traders towards a variety of suboptimal behaviors. This may include making high-risk trades, buying shares of an untested company or technology just because it is going up in price rapidly, or buying shares without researching the underlying investment.
Additionally, greed may inspire investors to stay in profitable trades longer than is advisable in an effort to squeeze out extra profits or to take on large speculative positions. Greed is most apparent in the final phase of bull markets when speculation runs rampant and investors throw caution to the wind.
Conversely, fear causes traders to close out positions prematurely or to refrain from taking on risk because of concern about large losses. Fear is palpable during bear markets, and it is a potent emotion that can cause traders and investors to act irrationally in their haste to exit the market. Fear often morphs into panic, which generally causes significant selloffs in the market from panic selling.
Regret may cause a trader to get into a trade after initially missing out on it because the stock moved too fast. This is a violation of trading discipline and often results in direct losses from security prices that are falling from peak highs.
Trading psychology is often important for technical analysts relying on charting techniques to drive their trade decisions. Security charting can provide a broad array of insights on a security’s movement. While technical analysis and charting techniques can be helpful in spotting trends for buying and selling opportunities, it requires an understanding and intuition for market movements that are derived from an investor’s trading psychology.
There are numerous instances in technical charting where a trader must rely not only on the chart’s insight but also their own knowledge of the security that they're following and their intuition for how broader factors are affecting the market. Traders with keen attention to comprehensive security price influences, discipline, and confidence show a balanced trading psychology that typically contributes to success.
Part of trading psychology is to understand why individuals make irrational decisions in the market or other money matters. Behavioral finance is a subfield of behavioral economics that proposes psychological influences and biases that affect the financial behaviors of investors and financial practitioners. Moreover, influences and biases can be the source of explanation of all types of market anomalies, specifically those in the stock market like severe rises or falls in stock price.
Behavioral finance typically encompasses the concepts of:
- Mental accounting: Mental accounting refers to the propensity for people to allocate money for specific purposes.
- Herd behavior: Herd behavior states that people tend to mimic the financial behaviors of the majority of the herd. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-offs.
- Emotional gap: The emotional gap refers to decision-making based on extreme emotions or emotional strains such as anxiety, anger, fear, or excitement. Emotions are often a key reason why people make irrational rational choices.
- Anchoring: Anchoring refers to attaching a spending level to a certain reference. Examples may include spending consistently based on a budget level or rationalizing spending based on different satisfaction utilities.
- Self-attribution: Self-attribution refers to a tendency to make choices based on overconfidence in one's own knowledge or skill. Self-attribution usually stems from an intrinsic knack in a particular area. Within this category, individuals tend to rank their knowledge higher than others, even when it objectively falls short.
Example: Loss Aversion
Loss aversion is a common psychological error that occurs when investors place a greater weighting on the concern for losses than the pleasure from market gains. In other words, they're far more likely to try to assign a higher priority to avoid losses than making investment gains. As a result, some investors might want a higher payout to compensate for losses. If the high payout isn't likely, they might try to avoid losses altogether even if the investment's risk is acceptable from a rational standpoint.
Applying loss aversion to investing, the so-called disposition effect occurs when investors sell their winners and hang onto their losers. Investors' thinking is that they want to realize gains quickly. However, when an investment is losing money, they'll hold onto it because they want to get back to even or their initial price. Investors tend to admit they are correct about an investment quickly (when there's a gain). However, investors are reluctant to admit when they made an investment mistake (when there's a loss). The flaw in disposition bias is that the performance of the investment is often tied to the entry price for the investor. In other words, investors gauge the performance of their investment based on their individual entry price disregarding fundamentals or attributes of the investment that may have changed.