• Tue. May 28th, 2024

Definition, Examples, Importance in Investing

What is Trading Psychology?

Trading psychology refers to the emotions and mental states 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 and 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 their trading plan. Fear and greed are commonly associated with trading psychology, while things like hope and regret also play roles in trading behavior.

Key Takeaways

  • 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 by the influence of both greed and fear.
  • Greed drives decisions that might be too risky.
  • Fear drives decisions that might 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 extreme that it sometimes clouds rationality and judgment. Greed can lead traders toward 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 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 significant 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.

Why Trading Psychology Matters

The performance of a trader’s portfolio is linked to the investment decisions made, which are in turn affected by the trader’s emotions, subjective inclinations and mental processes. Investment decisions may be arrived at through the use of fundamental analysis, involving use of data from a company’s financial statements and regulatory filings, along with data on economic conditions. Alternatively, technical analysis, may be employed for decision making, involving the use of historical market price and volume data. Regardless of the type of data used, biases (subjective prejudices), and heuristics (unconscious mental shortcuts and patterns), can affect an individual’s collection and interpretation of data. This can impact decision making and result in errors in judgement, potentially leading to suboptimal portfolio performance.

What is Behavioral Finance?

Part of trading psychology is understanding why individuals make irrational decisions in the market or in other money matters. Behavioral finance is a subfield of behavioral economics that identifies psychological influences and biases that affect the financial behaviors of traders and financial practitioners. Psychological influences and biases can help explain all types of market anomalies, including steep rises or falls in securities prices.

The Efficient Market Hypothesis previously assumed that market participants were rational and that markets were efficient, however, behavioral finance presented a challenge to this assumption. It acknowledged that market participants may be prone to biases and heuristics, which impact rational decision making. Behavioral finance therefore attempts to understand why people make investment decisions and how these decisions impact financial markets.

Behavioral Biases in Investing

Behavioral finance typically encompasses the concept of behavioral biases, some of which are outlined below:

  • Mental accounting: Mental accounting refers to the propensity of persons to treat different sums of money differently by allocating it into mental categories or “buckets,” rather than treating all money as interchangeable. An example, related to loss aversion (addressed later in this article), is the tendency of investors seeking cash to sell winning stock positions over losing stock positions. Selling the loser may be the more rational decision due to tax-loss benefits and the potential that the losing investment may be the weaker investment. The decision may nevertheless be taken based on the investor’s mental categorization of winners as different to losers and a distaste for loss-taking.
  • Overconfidence: Overconfidence is the tendency to overestimate one’s own abilities, skills and knowledge. Many investors believe themselves to be more skilled in investing than other market participants. It is, however, statistically impossible for most investors to be above average. Overconfident investors have the tendency to trade excessively, resulting in higher transaction costs and poor performance. Studies also show that overconfident investors overestimate their own predictive abilities, and precision of data given, resulting in emotionally charged behavior and excessive risk taking.
  • Herd behavior: Herd behavior states that people tend to mimic the financial behaviors of the majority of the herd. The natural human desire to feel like a part of the crowd, at times influences investors to follow the investment actions of others. When a crowd is generally going in one direction, an individual may feel uncomfortable or wrong for going in the opposite direction. As such, investors may follow the crowd by purchasing assets perceived to be purchased by the crowd, neglecting to do their own research and assuming that others have done research. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-offs. The dotcom bubble was a recent example of this, wherein investors following the crowd, purchased securities in many internet-based businesses in anticipation of future profits, which never materialized, resulting in a sharp sell-off.
  • 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 choices. As mentioned before, fear and greed are notable drivers of human behavior, which can result in overreactions, giving rise to unfounded optimism, irrational exuberance and asset bubbles, or conversely, market panic and major sell-offs.
  • Anchoring: Anchoring refers to attaching a financial decision to an arbitrary reference point. Examples may include spending consistently based on a budget level or rationalizing spending based on different satisfaction utilities. Investors may use irrelevant information, such as their purchase price of a security as a reference point, or anchor, for their decision making. They may therefore, hold investments which have lost value because they have anchored their estimate of fair value to their original purchase price. Such investors may hold the security in hope of its return to the purchase price, without regard to its future prospects or outlook.
  • Self-attribution: Self-attribution refers to a tendency to regard successes as resulting from their own personal abilities, while regarding failures to be the cause of external factors. 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. As such, an investor may attribute successful investment performance to their own superior decision making skills but attribute poor performance, not to poor decision making, but to bad luck.
  • Loss aversion is a common psychological error that occurs when investors place more weight on the concern for losses than the pleasure from market gains. Losses prompt more emotional reactions within investors than the impact of an equivalent amount of gains. In other words, they’re far more likely to prioritize avoiding losses over 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.

What Are the Main Categories of Behavioral Biases That Traders Face?

Traders generally face two categories of behavioral biases: cognitive biases and emotional biases. Cognitive biases are patterns of errors or blind spots in thinking that are common to human beings, which result from subconscious mental processes. These may include overconfidence bias, mental accounting and anchoring bias, among other examples.

Emotional biases are deviations from rationality arising from feelings, moods, perceptions, or beliefs. These include herding behavior, loss aversion bias and the emotional impacts of fear and greed, among others. Both categories of biases can result in irrational judgements and errors in decision making.

What Are Some of the Common Pitfalls of Traders Neglecting Trading Psychology?

Investors and traders are prone to behavioral biases and can encounter multiple pitfalls. These may include selling winning investments quickly while holding on to losing investments for too long in hopes of recovery to the purchase price. Traders may follow the crowd in chasing recent top-performing assets, ignoring the need for due diligence and disregarding data on future prospects of the investment. They may act impulsively on information received, based on their perceived superior investing abilities. Another pitfall may be trading excessively while underestimating investment risk and failing to adequately diversify investments. Emotional responses to feelings of fear or greed may lead to impulsive decision-making during periods of market volatility. Understanding the concepts of trading psychology can assist in making more informed and rational decisions.

How Can Traders Overcome Biases to Avoid Pitfalls?

In order to overcome biases, traders can employ many strategies. Improving education of behavioral finance principles can enhance self-awareness and improve decision making. Developing and sticking to a trading plan with trading rules and risk management practices, can provide a structured approach to investing, minimizing room for emotional decision making. Performing their own objective fundamental or technical analysis research on investment opportunities and seeking a range of data to support the analysis, including contrarian perspectives, can assist in avoiding herd-following behavior and challenge existing beliefs.

The Bottom Line

Trading psychology influences investors’ mental state and is as important as knowledge and skill in determining trading success. Biases or subjective prejudices, heuristics or unconscious mental patterns, and emotions such as fear and greed are strong drivers of traders’ decision making and therefore trading performance. Behavioral finance aims to understand financial decision making and how this affects financial markets. Some common behavioral biases include mental accounting, overconfidence, herd behavior, the emotional gap, anchoring, self-attribution and loss aversion. An understanding of these and other behavioral concepts can assist in improving decision making and trading outcomes.

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By admin