While we can put in place automated systems that pull the trigger, it’s still us that have to live with the consequences.
One of the biggest challenges we face is keeping our emotional state of mind in check and preventing it from following the path of least resistance. A good amount of evidence shows that the easiest path is generally the “crowd response” and the one most likely to result in a negative outcome.
And although our emotions cannot be detached from our decision making, we can try to understand how emotions can influence our thoughts and behavior.
Here are some of the mental and emotional challenges we all come up against when trading in financial markets.
Challenge 1: Dealing with a losing position
No matter how diversified and well tested a strategy is, there will always be times when it’s sitting in the red. When losses start to grow, the emotions will distort our perspective on reality.
Cortisol is released by the brain – this is a stress hormone that interferes with thought, memory and rational decision making. This process is very subtle and happens below the level of conscious awareness.
Humans are biologically motivated to try to avoid losses so it isn’t surprising this is especially testing on our psyche. The path of least resistance is to cut the pain as quickly as possible, regardless of what happens next.
Rather than trying to deal with the aftermath, it is better to avoid getting into this situation in the first place. While nobody can avoid losses altogether, we can control the size of those losses. Or more precisely, the size of those losses relative to our emotional “comfort zone”.
Being too emotionally invested in every transaction on your account doesn’t bode well for long term success – or your health for that matter.
Anyone who finds themselves stressed out or losing sleep over movements in their account is probably over-exposed to the market. They have too much at stake relative to their wealth.
Challenge 2: Don’t lose sight of the endgame
One of the biggest myths about trading is that somehow those who are successful must have an intuitive flair for second-guessing markets and that this is impossible for others to replicate.
This assumption is wrong. Traders who make money consistently are not achieving success by one, two or three winning trades. Or even a month of winning trades. They win because they have a tried and tested system in place, and that system has a known outcome for the amount of risk being taken.
Over time the system is able to create a positive return for every dollar it uses as working equity. For example, it might only be a return of 1 cent per dollar per month. It doesn’t really matter. What’s important is that it has a positive return on equity over time.
The difference between the pro and the amateur is that the pro looks for a long term return on capital invested, whereas the amateur treats each trade as an individual bet. This lack of system carries a heavy personal attachment if things go the wrong way, as they often do.
Challenge 3: The temptation to take money off the table
There’s always an urge to grab profits while they’re there. After all the market could turn and those greens could quickly turn red.
Human beings are naturally biased towards loss aversion. Experiments have proven that given a reward or loss of equal size, we feel the pain of the loss as being greater than the joy of the reward. This is not an emotion that’s easily shrugged-off either. It is so ingrained in all of us that it has been traced back to primates.
Be cognizant of loss aversion and try to resist the urge to take money off the table as soon as it’s there. Cutting winnings too early can sabotage a strategy and prevent it from ever realizing it’s potential.
Challenge 4: Coping with trader’s regret
How many times have you heard a colleague or friend say something like this? “I could have invested all of my money in Microsoft shares when they were 10 cents, and sold them at 100 dollars.”
Trader’s regret is that emotion felt when you could have bought but didn’t. It’s an acute emotional pain felt as a fear of missing out (FOMO) mixed with the remorse or anger of not acting on an early hunch.
The regretful trader usually sits back, brooding and fuming that the market is moving without them, and often telling everyone about it.
This emotion is extremely destructive to the individual it affects and does influence rational thought. It’s an emotion so powerful it can drive markets to unsustainable levels and has been responsible for creating enormous asset bubbles.
But it’s also just that; an emotion and not reality.
Trader’s regret emphasizes the winning outcomes. These are situations where we could have made a lot of money but didn’t. However we tend to ignore other situations where we could have made wrong decisions that would have resulted in big losses.
With hindsight, it’s easy to look back and think that we had all of the facts at-hand that we know now. But this just isn’t the case. There was probably a good reason why we didn’t do that trade in the first place.
For every Microsoft there were thousands of other IPOs that went to the wall after just a short time. Many investors lost a fortune backing these failures.
Accept that nobody can see into the future however much they’d like to. We make decisions based on the facts at hand, and in the present.
Challenge 5: Accept that you cannot control the market
One of the best lessons to learn early on is that you cannot control the market. Successful money managers do not spend their time watching every price tick on a computer screen. It isn’t productive to them because it is not something they can influence.
Moreover micro-analyzing the market has other negative behavior consequences. By watching every tick your emotional mood will swing according to whether the market is going for or against you.
As well as being highly stressful which in itself is bad, this emotional rollercoaster will often develop into poor judgement.
Market watching can cause a trader to make rash decisions such as closing a position too early if the price is going against them. It can trigger panic/fear responses such as capitulating out as the market bottoms (or tops).
When crowd fear is reaching a peak this is typically the worst time to exit and when losses will be greatest.
On the other side, being glued to the screen all day can lead to over optimism when things are going well. This routinely leads to taking on too much risk when the market is being kind to us.
Instead, use time to research the factors that influence markets rather than relying on intuitions and guesswork. Or analyze your trading plan and see how it can be improved.
Even so accept that you can do all of the analysis in the world, and do everything possible but sometimes the market just won’t go in the direction you expect it to. Accept that there are always circumstances that cannot be foreseen.