There was a great article in the Sydney Morning Herald on trading and why most traders lose money. Regular readers know that I focus a lot of time and energy on understanding not only the psychology behind my own trading, but also the psychology of other traders. General Patton once said: “if everyone is thinking the same then someone isn’t thinking”. These words are never more applicable than they are to markets. After all, the name of the game, more often than not, is being in the trade before anyone else expects it. Markets rarely move where the majority of investors expect them to move. The article broke down the reasons for losing into 7 different common emotional mistakes:
1. Emotional bias: the tendency to believe the things that make you feel good and to disregard things that make you feel bad. In trading terms, this means ignoring the bad news and focusing on the good news. It’s called losing objectivity; you don’t recognise when things go wrong because you don’t want to.
This is the primary reason why most traders lose money. I believe it is mostly due to the fact that the majority of investors are generally biased in their thinking. They are trained to believe that buying stocks is the best way to invest in a market. They therefore ignore the other side of trades or other asset classes. This bias generally leads to a permabull perspective (or a permabear perspective for the more pessimistic). The general optimism of most traders (or pessimism) leads to cloudy thinking. Learning to be unbiased and flexible are perhaps the two most important rules to becoming a good trader. Trading one asset class with one directional bias would be like a professional baseball pitcher deciding to throw nothing but fastballs. You have many options and pitches – utilize them all.
2. Expectation bias: the tendency to believe in things that you expect. In financial terms this means not bothering to analyse, test, measure or doubt the conclusion you expect or hope for. It is also known as the law of small numbers – believing in something with little real evidence.
Focusing too much on the macro picture can often lead to this kind of skewed thinking. Peter Schiff is a great example. His macro inflationary theme is likely to be correct over the long-term, but in the near-term he has cost himself and his investors a great deal of money by not being more flexible and being able to adjust to the micro changes in the economy. I expect this current bear market to persist much longer, but that hasn’t stopped me from being bullish at times during the last 18 months. The market is a dynamic system and is constantly changing. Learn to evolve and change with it.
3. The disposition effect: the tendency to cut your profits and let your losses run – the opposite of what a trader should be doing. Making small profits and big losses is a recipe for disaster.
This is almost entirely due to a lack of discipline. All investors should have rules. Have price targets and set stops. Learn to be robotic in your investing style. If you give your emotions the opportunity to get in the way of your trading I can guarantee you they will. Hope is not a strategy when a trade doesn’t go the way you planned. One of the best parts about the stock market is that polygamy is perfectly acceptable. You aren’t married to any single position. Learn to “dump” the losers and move on to the next trade.
More over at TPC…
Also at the Sydney Morning Herald “Why you behave like a loser”