Skill Sheet: What You Will Learn Here
- Pitfalls of emotional biases in trading
- How to manage emotional biases
Being successful in the stock markets depends a lot more on psychology than intelligence. While intelligence is important, temperament is indispensable in the market.
The markets are made up of people who trade stocks based on their understanding. They are motivated by prejudices and behaviour that are unique to themselves. The subject of psychology is the one that most effectively explains human motivations and feelings. Understanding the causes of people’s feelings, thoughts, and behaviour is useful.
Market psychology is the term used to describe the mood of those who are actively trading in the financial markets. Market performance can and does frequently move in a direction that diverges from the fundamentals due to investor emotion. The markets may decline, for instance, if investors suddenly lose faith and opt to withdraw.
Pitfalls of emotional investment decisions
While investing, our decisions are frequently influenced by emotions. It’s extremely challenging to overcome emotional biases. Traders encounter a variety of emotional biases during trading, including greed, fear, hope, exhilaration, and panic. Keeping emotions in check is the mantra for success.
Individual investors will typically have poor long-term success if they let their emotions control their investment selections. According to me, the typical investor can have two different emotional responses.
The emotionally driven decision comes from the fear of missing out (FOMO). These investors will chase stocks that appear to be doing well for fear of missing out on making money. This leads to speculation without regard for the underlying investment strategy. Investors can’t afford to get caught up in the “next big craze” or they might be left holding valueless stocks when the craze subsides. FOMO can encourage speculation.
Fear of losing everything (FOLE) is the other emotion that investors frequently experience. While investors do not want to be left out, their fear of losing all of their money is a more potent emotion. People may grow uneasy when volatility creates significant swings in the stock market and sideline their assets to prevent a significant sell-off or stock market disaster.
The global markets are more interconnected now than before. News from across the world can have an impact on the local market. This has a domino effect, leading to a selloff, followed by additional selling by investors reacting to this fear of losing their money. Professional short sellers such as hedge funds or algorithmic trading programmes add to the selling pressure to take advantage of the circumstances.
How to counter emotional investment decisions
An investment plan can neutralise emotional biases to a great extent. Devising a plan that includes stocks with low volatility, for instance, can be good. Minimal exposure to stocks primarily focused on commodities such as oil and precious metals can help investors minimise emotional reactions.
Staggered buying and selling can be another technique to eliminate the FOMO and FOLE effects. Staggered buying and selling involves buying at predetermined levels that can be based on some percentage or support/resistance level.
Diversification is an important fundamental principle to minimise emotional reactions because the stocks are internally hedged and mitigate risks.
Planning is critical in investing as it brings objectivity and avoids speculation. Having a strategy in place helps during a period of volatility and in avoiding panic selling or chasing a euphoric stock. Most importantly, cultivating patience and trusting the investment thesis will help in better outcomes.