If you are a seasoned investor, you probably hail Warren Buffett as your investment guru or at least, one of your gurus. Have you heard his famous saying – The most important quality for an investor is temperament, not intellect? Buffett embodies this investor psychology whenever he invests.
For instance, during the 2008 financial crisis, Buffett maintained his calm temperament and invested heavily in undervalued stocks despite the market's turmoil. He believed in the fundamental strength of the companies he invested in and was patient while waiting for the market to recover. This strategy ultimately paid off, and he made significant gains when the market eventually rebounded.
However, even Buffett was prone to market commentary. In 2007, Berkshire Hathway invested considerably in put options, even though Buffett had famously called derivatives “weapons of mass destruction”. During the 2008 crisis, these took a hit. However, his other smart investments helped him through this.
A trader or investor who is just starting out in the market may be tempted to give in to market sentiments. For instance, when markets are doing very well, they may be tempted to buy into the market even if a company doesn’t exhibit strong fundamentals. On the flip side, when the market is tanking, fear may motivate them to sell low for they may be scared to lose even more money! However, the key to successful investing does not lie in timing the market, for even the best investors fail to do that! Instead, it is about developing discipline and continuing to invest through market highs and lows without giving in to your emotions.
In this article, we’ll walk you through the different forms of psychologies at play in trading and how you should navigate them when you operate in the stock market.
What is Trading Psychology?
Trading psychology or stock market psychology is a term that is used to refer to the emotional and mental state of traders when they make investment decisions in the stock market. It comprises various emotions that traders experience when they buy or sell socks in the market. These emotions can range from fear, greed, hope, and regret to anxiety, excitement, and overconfidence.
For instance, imagine a trader who has employed all the required tools to identify a good opportunity in a sporting company. She identifies the entry level, the stop loss and the profit level for the trade. She executes it at the right time. However, after a while, the stock starts tanking. She second-guesses her decision and stops the trade before it hits the stop loss level to protect herself from losses. However, a few minutes after she closes her position, the stock rebounds and moves in the direction she had predicted. Her trading psychology of fear costed her potential gains!
Identifying and staying on top of trading emotions is important for stock traders or investors because it is intricately linked with their ability to make buying and selling decisions, which in turn affects profitability. For instance, as in the example above, if a trader allows their fear to affect their trade, they may make an impulsive sell decision based on their current mood rather than solid research or analysis. This can lead to losses and missed opportunities.
Moreover, traders who rely on their solid understanding of trading psychology can identify an emotion when it arises, manage their emotions, remain disciplined and be rational in their decision-making rather than making on-spot decisions. This can help them avoid poor trades in the long run, thereby leading to more sustainable profit.
Prominent Trading Emotions That Traders Face
There are a range of trading emotions that one might feel when they dabble in the stock market. Some of these we have already mentioned before. Here, we’ll cover the most common triggers of psychology that traders may face during their regular trading cycle:
Fear is perhaps the most common trading emotion that you may feel as a stock trader. Fear is a normal human response when facing a threat. Stock trading can be thought of as the contemporary emotional equivalent of hunting a predator like a bear. You may have your plan spot on, but you are still scared of what may happen if the bear catches you at the wrong end (pun intended!). Fear can lead to a sleuth of poor decisions such as loss aversion, overtrading that leads to higher transaction costs, confirmation bias where you go looking for evidence that confirms your fears, or inaction bias where you are too scared to make any decision. When the fear of trading creeps in, here are some questions to ask yourself:
- What is causing my fear?
- Have I done my research?
- What is my investment strategy?
- What is the potential loss?
- Do I have a loss-covering situation?
- Am I investing in a position larger than the amount of risk I can take?
- What is the worst-case scenario?
The flip side of fear is greed. While fear can hold you back from taking reasonable risks, greed can push you to take on too much of it. While some amount of greed is necessary to win the game of investing in this capitalistic world, you need to temper it and keep your greed within bounds. Avoid being blindsided by greed to chase high returns without fully understanding the amount of risk you are taking on. Greed can push you to overlook fundamentals such as company financials or management and take a bet just because the market is rallying. Greed is also an emotion that often develops later in the bull market, causing roll-over emotions like overconfidence to take root. Even if you don’t buy at a high, you may hold your position for too long, causing you to miss potential gains. Some of the questions to ask yourself for greed-check are:
- Am I setting unrealistic expectations for my trade?
- Am I taking on more risk than I can stomach?
- Am I ignoring warning signs on this stock?
- Am I investing according to my investment strategy and goals?
Hope is a complicated emotion because it can have both positive and negative impacts on. On the positive side, hope can inspire optimism and confidence in traders.
However, hope can also lead to unrealistic expectations and irrational decision-making. When traders hope for a specific outcome, such as a company announcing positive earnings, they may ignore warning signs and continue to hold onto a position even as it becomes increasingly risky.
This can lead to significant losses if the outcome does not meet their expectations. Creating realistic hope can help with trading. For instance, if you have a strategy for investing, you may have expectations that are realistic. Without a strategy, all kinds of trades will be done on foolish and unfounded hope. Some of the questions to ask yourself to prevent hope-based trading are:
- Why do I believe this company is going to perform well?
- Do I really understand the company’s financials and fundamentals?
- Am I trusting this stock because of how the market expects it to perform?
- Am I expecting unrealistic returns?
- Have I done my research?
Regret is a feeling of disappointment or sadness that occurs when you miss an opportunity or fail to meet certain expectations. When it comes to investing, regret can manifest in several ways. Regret can result in you making impulsive decisions because of an earlier instance of missing out. You may give in to a buy decision purely because you missed an earlier high.
You could also base your decision to buy now based on missing out on previous high returns or past stock performance. You could also end up buying more than your capacity because you missed an opportunity to do so in the past. To avoid regret-based investing, always have an investing plan and rules for yourself.
Process regret in a smart way, wherein you create strategies to avoid mistakes you did in the past instead of getting hung up on them. Ask yourself questions like:
- Is my current view of the market coloured by a past decision?
- What is giving rise to regret in me now?
- Do any of the indicators indicate that the situation is going to repeat itself?
- Does my analysis support my decision or is it based on my emotional response?
Some of the other emotions that you may feel as a trader include overconfidence, ego, frustration, anger, excitement, nervousness, among others.
Following a similar pattern of asking yourself questions about why you are investing can help clear up whether you are being overridden by emotions or you are making a rational decision.
How to Raze off Investing Biases and Emotion-driven Trading
Once you have understood the different market psychologies and trading psychologies at play, adopting some simple practices can keep trading emotions at bay. Managing emotions while trading in stocks can be challenging, but there are several strategies you can use to help keep them under control. Here are some tips:
Stick to What You Know
Stick to the stocks that you know well and understand. Don't try to trade in something just because it's popular or trendy. Familiarity with the stock and industry can help reduce the chances of impulsive decisions.
Develop a Trading Plan
Have a clear trading plan that outlines your entry and exit points, risk tolerance, and profit targets. This will help you avoid making emotional decisions when the market is volatile.
Keep a Checklist
Create a trading checklist that you can follow to ensure you are making decisions based on logic and not emotions. This checklist should include items like analysing market trends, reviewing financial statements, and tracking news and events that could impact the stock.
Properly allocate your investments across different stocks to minimise risk. Avoid putting all your money into one stock or industry.
Test Your Hypothesis
Test your investment hypothesis by doing research and using data to support your decisions. Avoid making decisions based on rumours or speculation.
Avoid comparing your investments to others. Everyone has a different risk tolerance and investment strategy, and comparing your investments to others can lead to emotional decision-making.
Understand the Difference Between Price and Value
Understand the difference between the price and value of a stock. The price of a stock can fluctuate due to market conditions, but the underlying value of the stock may not change.
Set Realistic Expectations
Set realistic expectations for your investments. Don't expect to get rich overnight or make consistent profits in a short period of time.
Practice Risk Management
Practice risk management by setting stop-loss orders and not investing more than you can afford to lose. This will help reduce the emotional impact of losing money in the stock market. Top of Form
Emotions are part and parcel of human beings. You can’t get rid of your emotions, but you can learn to manage them better. Trading psychology refers to understanding and handling emotions that arise as a result of trading. These could range from fear, anxiety and regret to greed, overconfidence, hope and excitement.
While it isn’t possible to eliminate emotions from your system, asking the right questions and developing a framework to combat these trading emotions can keep you from making decisions that are emotions-driven. For instance, developing a trading plan, having an investment hypothesis and effectively testing it, setting realistic expectations from investing and managing risk better can all help you make rational investment decisions.
When in doubt, use Trading Models such as the ones created by Investmint to help you make better investment decisions.