There is significant data that reveals a high correlation between an investor’s psychological traits and their investment decisions. Behavioural finance studies the effect of mental biases on financial decisions. But why is this so important?
Investor behaviour often deviates from logic and reason, despite all information at hand, leading to decisions based on emotions. Emotional processes, individual personalities, careless mistakes and even the health of a market player affect decision making. It is necessary to study these aspects, not just to protect investment portfolios, but also to understand market crashes. At a macro level, the mental processes of a group of traders, collectively effects the movement of the financial markets. For instance, “representativeness” is a term used to signify increased appeal of a financial instrument, based on past performance parameters.
Forex traders can choose to buy a currency on expectations that its price will climb in future, ignoring other assets even when their prices fall below their intrinsic values. Let’s see a few more examples of trading psychology that could hurt your profit potential.
Performance anxiety, a common term heard with respect to sports, examinations, public speaking and more, is applicable to trading as well. Not only fear, but increased self-doubt and extra cautiousness can hurt trading decisions. Increased attention to trades can at times work against you. In the financial markets, this is often called “analysis paralysis.”
The interesting thing about such anxiety is that it occurs as much with success as with losses. Many traders become nervous when they start making profits, leading them to close positions prematurely for fear of the profit turning to loss. In short, increased profit making can create pressure to maintain the success levels.
For long term success, maintaining objectivity in trading decisions becomes important. A string of losses or gains are common in trading. But when they impact the next trading decision, they could become harmful. Performance anxiety can also arise out of unrealistic expectations from the market.
It is good to be achievement oriented and dedicated to success, but profit goals are best set according to market conditions and one’s trading tools. Setting unrealistic goals can lead to increased tension and disappointments while trading. These can then lead to a chain effect, which results in self-doubt and desperation, colouring trading decisions.
It makes much more sense to have process goals. Focusing on specific trading plans, fixed entry and exit levels, definite stop-loss strategies, position sizes and more, can enhance the potential for success.
Setting unrealistic goals can also lead to over-trading, which might seriously impact your trading account.
It is not just the quest of profits that leads to overtrading. Such behaviour is also associated with overconfidence. Not all traders become wary of increased gains, some allow success to get to their head. Overconfidence, fuelled by success, can blind traders to what is actually happening in the markets. No single strategy works equally well under all market conditions. So, continuing with a strategy that brought you success, despite changing market circumstances, could quickly lead to escalating losses.
Trading depends on a lot of factors. Markets vary from one day to the next. Examples of overtrading include trading in low volatility conditions, trading even after stop-losses get triggered or trading on excessive leverage and large position sizes.
One way to prevent such situations is to maintain a trading journal, in which you can record every trade and strategy. This can help you see where things went wrong and what to avoid the next time around.
Even the most successful traders encounter losses. What sets them apart is their ability to bounce back. Of course, you will feel disappointed or even disheartened by losses. That is very different from allowing such feelings to impact your next course of action. If fear colours your decisions, you might find yourself getting out of trades sooner than necessary or hanging on to trades beyond a reasonable point.
After a series of losses, there are traders who might start believing that they don’t have the skills to be successful in the financial markets. The key to surviving for the long term is to look at losses as opportunities to learn and hone your trading skills. A constructive attitude can help you rebuild confidence and get back on the horse, or in this case, the trade terminal.
It is a common instinct to follow what many others appear to be doing. While it is a great idea to look at the strategies used by successful traders and even use copy trade functionalities, it is best not to succumb to the impulse to blindly imitate others’ trades. Studies have found that traders tend to place too much emphasis on results derived from small sets of data or from reputed sources. While they may be valuable, it is always wise to do your own research and analysis, before entering into trades.
Chasing trends is also a common trading bias. Although most financial products come with disclaimers like “past performance is not indicative of future results,” investors could still blindly get into markets they know nothing about. Remember, if you find a trend, the chances are high that others have already exploited it before you.
Emotions are an integral part of trading. But there are times when they could sabotage your trades. It is important to identify such emotions and work to remain objective while making trading decisions.