Where trading and investing in stocks, options, futures, forex, etc are concerned, there is no doubt that people have a tendency to behave strangely. Exhibiting irrational behaviour is common. People come up with all sorts of reasons and excuses for the way they are behaving, even while subconsciously admitting that they are deviating from their plan without valid reason.
The field of Behavioural Finance attempts to interpret and understand why people behave the way they do with financial activities. It is an investigation of how people’s decisions are affected by cognitive errors and emotions.
Some key points in Behavioural Finance are:
- The ‘Fear of Regret’ – where people beat themselves up about incorrect decisions or errors of judgement. They avoid this pain by holding onto positions that are moving against them, despite the intelligence that they should exit the trade while the loss is small.
- People are more upset by potential losses than pleased by wins.
- People perceive chance wins as trading success.
- The more people win, whether by method or luck, the more confident they become. This is very dangerous for those who win by luck.
- People are more exuberant and optimistic on bullish days and depressed and pessimistic on bearish days.
- People tend to make irrational decisions reflecting biased or wrong beliefs. People have a tendency to cling to beliefs, even when presented with evidence to the contrary.
It is important to understand that emotions and intuition can lead to poor decision-making at times. Never trade on gut-feeling, intuition or untested ideas. Don’t desperately try out new ideas in the hope that they will be the solution to your trading woes. These un-researched and under-tested ideas lead to disappointment and poor decision-making at times when calm and order are required.
To minimise the risk of making irrational or stupid decisions in trading we must set up guidelines and rules. Trend trading with a written plan or system is a crucial factor in being successful in the market. A second crucial factor is the patience and discipline to follow your system without doubt or deviation, even when it appears times are tough.
If you trade without a system you are unlikely to be successful. The concepts behind Behavioural Finance indicate that if you have no plan, but win some of the time, the wins will appear more significant, you will develop over-confidence in your abilities, with the result that you will begin to take greater risks.
Ultimately, you will lose if you follow this path. You must know in advance what you will do in any market situation. Never place yourself in a situation where you are making decisions on the run – faced with a plummeting market and no pre-determined strategy to cope with such an event.
Most people tend to overtrade – I doubt there is one successful trader who would not admit to having over-traded at some point in their trading career – it is a common fault among new (and not-so-new) traders. Following a loss, they become fearful of more losses, so they ‘revenge’ trade to try to win back the losses. These trades are usually ill-thought out and result in more losses, which results in more fear. Eventually these traders may self-destruct and quit the market, disillusioned, broke and believing that trading can never work.
People who overtrade and win are at risk, too. The euphoria leads them to jump into more and more trades without proper analysis. They expose themselves to too much risk, believing they are invincible.
Generally, the more often people trade, the less they earn. There is a perception that short term trading is less risky and more profitable than long term trading, because you are getting out of trades earlier and naturally have stops closer to your opening position. However, the opposite tends to be the reality. You are risking your money more often.
Trend trading with a set of rules – a checklist for every scenario – will allow you to trade without distraction or doubt. You will be confident in your decisions and will be happy with the result. A loss taken with the conviction that it is the best course of action need not be an unhappy event. It builds confidence in your ability to make correct decisions for your trading style and personality.
To be successful in the market, you must be systematic in your approach. You must have rules. Follow those rules. Don’t be distracted by outside news and events. Have a strategy in your rules to deal with such things.
Trend trading is a skill and strategy that can be used in any market, be it stocks, commodities, futures or forex. Learn it well and you will succeed. Remember that your aim should not be to make money in the markets but to be the best trader you can – then the money will follow.
Take heed of the words of Richard Driehaus – “Everyone wants to be rich, but few want to work for it.”
Most buyers and sellers in the financial markets do so without any plan, discipline or risk management. It takes strength of character and courage to do what others are notdoing, but ultimately, you will be the winner.