What Is Trading Psychology and Why Does It Matter?

Many individuals may not realise that investing is an emotionally driven activity. For instance, when cryptocurrencies became a mainstream commodity, dozens of beginner, intermediate, and expert investors joined the trend out of a fear of missing out, a concept described in social psychology as the bandwagon effect.

For years, emotions such as fear, happiness, anger, and greed have presented themselves in the market. They can affect an investor’s decision-making process positively and negatively, dictating one's success or failure in investing in stocks and other financial instruments. Developing self-awareness skills is one of the best ways to counter any emotions or behaviours affecting your ability to make good investment decisions.

By reflecting, you can match the cause with the emotion to ensure you’re in the right state of mind when you log into a platform for investing. Industry experts refer to this idea of our emotions acting as catalysts for market investing in our trading psychology. We will explore this branch of behavioural economics in this article, including why it matters and the various plans you can put in place to better your emotions.

• What Is Trading Psychology and Why Does It Matter?
• Investment Biases
• 5 Steps to Recognising Your Emotional Mindset?
• Top Books to Read about Trading Psychology
• Key Takeaways

What Is Trading Psychology and Why Does It Matter?

Trading psychology relates to an investor’s emotional and mental state while making investments in the stock market. It also refers to an individual's emotional state as they enter and exit an investment platform. While every investor is different, the primary emotional catalysts associated with trading psychology include greed, fear, and regret. Also, positive emotions like confidence and pride can influence whether an investor secures a profit or sees heavy losses.

For example, feelings of greed can distract your judgement and rationality. This desire for wealth may trigger irrational investing, where you conduct high-risk investments or purchase shares without conducting proper fundamental and technical analysis. Fundamental analysis means looking at the overall economy to evaluate a stock’s value; technical analysis measures a stock’s future by looking at movements in its price and volume.

Likewise, fear is a compelling emotion that can cause you to exit markets too soon. Investors may also refrain from taking risks because of loss concerns. Fear can sometimes turn into panic, which causes the price of a security to drop without reasoned analysis.

Positive emotions like confidence can also have negative implications when it is not balanced and reaches extreme levels. For example, one concept in behavioural finance is self-attribution. Self-attribution refers to an investor’s tendency to decide based on overconfidence in themselves and their skills. Overconfidence in not just oneself but a particular market may lead to heavy losses if investors wait too long, thinking the market will make a comeback.

Investment Biases

It is not just your emotions that can influence investment activity, but innate biases that you may not realise you have. Biases can affect investments as they are often predetermined. They may also result in investors acting on a gut feeling rather than conducting rational analysis. There are many cognitive biases you should notice to overcome them quickly and efficiently. Some of them include: gambler’s fallacy, confirmation bias, representative bias, and status quo bias.

Gambler’s Fallacy

Gambler’s fallacy is a bias where an individual believes the likelihood of something happening becomes higher or lower as an event or process is repeated. Let’s say an investor continues to increase their position in a stock despite witnessing repeated and mounting losses. This investor believes that the stock price will most likely change direction as losses continue to increase, but this mentality is incorrect. Each event is independent, and there is no correlation between past and present occurrences.

Confirmation Bias

Confirmation bias is another common cognitive bias where you look for, believe, or favour information that supports/confirms your pre-formulated values or beliefs. Investors may also intentionally ignore information that contradicts these values and beliefs. For example, if you are steadfast in owning shares of a company, such as Tesla, Amazon, or Alphabet, and you may ignore unfavourable news about that particular company’s quarterly reports, you are committing a form of confirmation bias.

Representative Bias

If you are repeating investments for no other reason than because they previously brought you success, this is an example of representative bias. Another example is if you believe an investment is good or bad based on a company's past performances. Let’s say a business you have invested in releases a strong earnings report. You may assume that the next earnings report will be just as strong, but, as you now know through the gambler’s fallacy, past events don’t change the likelihood that certain events will occur in the future.

Status Quo Bias

Like representative bias, status quo bias means you are conducting old investments or using old strategies rather than exploring new options. If you are using old methods to execute new investments, you may be blinded by your perceptions and cannot recognise that the market has changed and your old strategies are not viable.

How Do You Recognise Your Emotional Mindset?

Recognising why trading psychology matters is as important as identifying the emotions, traits, and behaviours influencing your mindset when conducting investments. Below are five steps that will aid with this realisation:

Step One: Recognise Your Emotions, Biases, and Personality Traits

To recognise any negative emotions or personality traits that could affect your decision-making ability, the first thing you should do is to note how you feel when you log into an investment platform. Are you overwhelmed? Do you look for the best-performing stocks of the day and make assumptions about their future without proper analysis? Or, do you automatically check the price of a stock that previously gave you success?

Self-awareness and looking inward are crucial in trading psychology, and recognising from the start where these emotions and biases stem from will prevent you from making impulsive decisions or acting out of frustration. It's important to recognise your strengths and utilise them. For instance, if you are calm and confident without being overbearing, you can use these traits during your time in the market.

Step Two: Create an Investment Plan

Having an investment plan is also important in lowering the risk of your emotions causing you to behave irrationally in the market. You can work with your broker to create an investment plan or build it yourself. A good investment plan will include exit rules and mental preparations, like
a market mantra that you repeat before the day balances your emotions. As for exit rules, implementing stop-loss orders is one way to exit an investment if it goes against you. Stop-loss orders limit risk, and you can instruct your broker to close a position once it has reached a specific loss level. Investment plans should also include realistic profit targets, risk/reward ratios, and entry rules.

Step Three: Work on Developing Positive Traits

Getting rid of negative emotions and personality traits can help you. It allows you to develop new and more positive traits, such as patience and adaptiveness. Investment plans are one of the best ways to encourage patience because they help you separate the present from your long-term financial goals. However, patience also comes from understanding that market volatility is normal, not personal, and time is on your side. Similarly, learning to become more adaptive is crucial in maintaining your investment plan. For example, just because you have set out a plan does not mean you should never revise it or adapt it to new trends and market movements.

Step Four: Learn When to Walk Away

A fundamental skill in any investment is knowing when to take your losses and walk away. Just because you have lost does not mean you are a failure, or you should rush into making another investment to make up for some of your losses. Sometimes an investment won't work out, and it's important to recognise why this happened and adapt your trading strategy. Use a loss as an opportunity to learn about what went wrong and then use that knowledge to make better decisions in the future.

Likewise, investors should know when to walk away after a succession of wins. Luck always runs out, and you do not want to take unnecessary risks or gamble on your acquired profits because you are overconfident and happy. We talked about how anger can cause you to make irrational decisions, but happiness also has this effect.

Step Five: Write Everything Down

People keep diaries to express their emotions about particular life events. You can also keep a log to record how you felt during a particular investment. This will give you a good sign of what you did well or where your emotions and decision-making led you astray.

Top Books to Read about Trading Psychology

Reading is one of the best ways to improve as an investor. Below, you will find two well-known works that explore how psychology works in trading and investing.

Trading in the Zone by Mark Douglas

Trading in the Zone by Mark Douglas explores why investors take shortcuts in the market and why greed and fear have such an incredible hold over individuals. Douglas also provides solutions for how to prevent these issues from happening.

The Investor’s Quotient by Jake Bernstein

You can view Jake Bernstein’s book as an extension of this article. The author explores why investors fail because of their emotions and psychology. Bernstein also provides strategies and tactics for preventing and dealing with emotionally driven issues.

Key Takeaways

•     Investing is an emotionally driven activity, and these emotions can have negative affects on your decision-making process

•     A compromised decision-making process can determine your success or failure in investing in securities

•     The most common emotions associated with trading psychology include greed, fear, happiness, regret, pride, and confidence

•     Greed can cloud your judgement and cause you to make an irrational investment decision in pursuit of wealth

•     Some of the most common biases include confirmation bias, representative bias, status quo bias, and gambler’s fallacy

•     There are different ways to improve your trading psychology, such as recognising your emotions, creating an investment plan, developing healthier personality traits, and learning when to walk away

•     It is also a good idea to keep a log of your emotions when conducting investments so you do not make the same mistakes in the future