Understanding Trading Psychology
Trading Psychology Basics
How do you be emotionless while trading?
While it’s impossible to completely eliminate emotion from human thinking, there are ways to limit irrational thinking while trading. The key is to understand the cognitive biases that humans have and adjust your behavior accordingly. In addition, don’t deviate from investing plans you’ve made in advance just because of a downswing in the market, as you’re likely to react too strongly out of fear.
What is trading psychology?
Trading psychology is the application of the field of psychology to financial trading. Doing so allows you to understand the ways in which humans react to financial markets in ways that follow human biases. This can help understand how the market works the way it does as well as minimize these in your own trading. The relationship between finance and psychology is explored in the field of behavioral finance.
What cognitive biases undermine traders?
While virtually any cognitive bias or other psychological pitfall can hurt trading, two of the most common are confirmation bias and the sunk cost fallacy. Confirmation bias is when you give more weight to data that confirms what you already believe while giving less to info that proves you wrong. It’s critical to try and work extra hard to evaluate and take onboard data that disproved your ideas, as your first instinct will usually be to discount it. The sunk cost fallacy is the idea that previous losses or costs should contribute to your decision, making when nothing you can do will get them back, and so you should only make trading decisions based on their effect on the future. For example, if you’ve invested a lot in a business that turns out to have a bad business model, you should act as if you were looking at it as a fresh investment without regard for money you’ve lost previously.
Behavioral finance is a field that looks at finance from a psychological perspective. It attempts to figure out the human biases and patterns of thought and behavior that affect financial markets.
Anchoring bias is a tendency for people to overweight the importance of the first piece of information they have when making a decision. This can happen regardless of whether the information is relevant to the decision.
Hindsight bias is the tendency for people to believe they had predicted past events when they hadn’t. This leads to people believing they are better at prediction than they actually are.
Sunk Cost Trap
The sunk cost trap is the tendency for people to stay committed to a course of action because they’ve already put a large amount of time or money into it. This is a fallacy because money or time already lost cannot be regained and so should not factor into decision making. It is also known as the sunk cost fallacy.
Analysis paralysis is the phenomenon where a person becomes unable to make a decision due to their inability to stop examining it. Due to the diminishing returns of additional research, analysis paralysis can cause people to lose out on opportunities for little benefit.
Herd instinct is the tendency to follow what seems to be a broadly accepted idea rather than doing your own research. Earnings forecasts are vulnerable to this phenomenon. Analysts, who are meant to be independently analyzing a company, will ensure their final predictions aren’t significantly out of line with the consensus.
Confirmation bias is the tendency for people to give more weight to information that supports what you already believe. This causes people to hold on to incorrect ideas because they undervalue information that disproves the idea.
Hot hand is the idea that succeeding in an action, such as shooting a basketball, will lead to an increased chance of success in future attempts. It was originally considered to be a fallacy, but current evidence is more mixed as to the existence of this phenomenon.