Guest contribution published on April 10th, 2017
About the author: Laurens Bensdorp is the founder/CEO of Trading Mastery School and the author of bestseller The 30-Minute Stock Trader: The Stress-Free Trading Strategy for Financial Freedom. He has been making a risk-adjusted return of more than five times the S&P 500 since 2007.
Note from Sure Dividend: Sure Dividend advocates long-term investing, not trading. With that said, there are many important psychological tips to learn from traders. This article covers the emotional/psychological aspect of investing.
The first horrible trading habit I have to help my students break is always the same. They watch the news.
They believe they’re objective, data-driven investors because they keep abreast of current events.
What they don’t understand is that knowing what’s going on in the world, and making intelligent decisions with that information are two different things.
What tends to happen is this. A person will hear a news story that somehow relates to their investments, and depending on their emotional state, their brain will spin that information in one of two ways.
When Things Are Going Well, Greed Takes Over
It’s human nature to believe that however things are now, they are going to continue on in the same fashion. In basketball, this is called “The Hot Hand Fallacy,” and it occurs when people assume that because one player has yet to miss in a game, that same player will continue to make every shot.
In trading, this fallacy combines with our natural tendency towards greed to create real disasters.
Imagine you’ve invested heavily in Fictional Company X, and you’ve seen great returns over the last year. You’re excited, and as well as things have gone, you keep imagining them going a little better. Then, the following happens:
- You hear a news story about a potential Fictional Company X acquisition.
- You think the acquisition is going to be great for business.
- You buy more shares of Fictional Company X, positioning yourself for the price rise.
On the surface level, this seems great. You’re making a decision based on information that you believe will lead to positive results for your bottom line.
Here’s the issue: You aren’t making a decision based on what the data is telling you, you’re making a decision based on what you want the information to mean.
The most likely outcome in this situation isn’t that everything goes great for you. It’s far more likely that your greed and confidence will lead you to be buying too many shares and ending up in a position you regret.
When Things Are Going Bad, Fear Takes Over
In the same way that humans are confident that the good times will keep rolling, we also tend to believe that our bad times are permanent.
In trading, that fear can cripple you.
Let’s run through a scenario similar to the one we discussed previously. Imagine you are trading according to a strict system (as I advise all my students to do), and you’ve bought a lot of shares in a company with the expectation that you will sell your position 6 months from now.
But you’ve taken some hits lately. You’re in month 3, but you don’t like what you see, and a news story comes on about the company you invested in—and it’s not all roses.
If you let that information justify your purely emotional decision to exit earlier than you planned to and sell your shares, you’re trading based off impulse.
Successful traders may be a lot of things, but they are not impulsive.
When there’s money on the line, it’s hard to quiet the voices of greed and fear. But it’s possible.
Two Keys to Developing an Emotionless Trading Strategy
You need to build an automated system that works for you.
Intuition, market reports, hearsay—none of these things are reliable enough for a good trader. An automated system with steadfast criteria won’t fluctuate according to your emotions.
Beyond making more reliably profitable decisions, an automated system has another less spoken about benefit: It takes the stress out of investing.
Whether you’re developing the computer system yourself, or hiring a developer to do so, you need to ask yourself two things:
- What systems can my personality handle? If you’re a manic person who needs to be constantly checking the markets and making moves (no judgements here), a long term trading approach where you hold investments for months will not work for you.
- How much am I willing to put on the line? If you lost $50,000, would it break you? Could you live 6 months in the red? Most people have a much smaller risk appetite than they believe they do.
Once you know what you can handle, you can start putting together analytical, data-driven systems that will make money despite your emotions.