Psychological Aspects of Trading
gsm.ucdavis.edu
I have recently been reading a study by Terrance Odean, an
assistant professor at the University of California. Odean
received the trading history of over 10,000 accounts that where
active been 1991 and 1996 from a discount broker and used the
data to study the trading behaviors of online investors. Not
surprisingly, most of them underperformed the stock market and
only a small minority beat the market. In fact only half of
active traders managed to just break even and only 1% generated a
monthly return of over 5%. Professional investors do not fare
all that much better as half of all mutual funds fail to beat the
S&P 500 index every year.
The failure rate of investors and traders is a different picture
than that which is portrayed by online and traditional brokers
through their advertisements. In fact if most people actually
lose money in the stock market, then the market is more like a
pyramid scheme in which wealth is simply transferred from the
mass and given to the brokers, stock manipulators, market makers,
and a small super trading elite at the top than the get rich
fantasy that is so often presented. A view that some might find
romantic would picture it as a pure Darwinian survival of the
fittest and leave out the part about the manipulators. One would
need more data to confirm if either of these views are true. A
study on how many trading accounts are opened and closed would
prove or disprove this. If brokers must continually recruit new
accounts to replace ones closed due to losses than these two
pictures of the market are correct. Money earned outside of the
market is brought into it and given to professionals and
manipulators. Just like a ponzi scheme, more money has to be
recruited to keep the engine running. For a pyramid to continue
new blocks must be placed on it. No matter how the market is
structured, what is more interesting is trying to figure out why
it is that many people lose money and a few make a lot of money
in the stock market. What can we learn from that to increase our
own returns?
How do most people lose money? Odean’s trading data shows that
almost all individual investors generate poor returns by selling
winning stocks too soon and holding on to losers. He argues that
they do this because they are “overconfident.” They consistently
believe that their losers will come back and the market ends up
proving them wrong. When they have a winner they sell them too
so, fearing that it will become another loser.
Odean’s study provides a great resource to record the behaviors
of active investors. However, any conclusions about motivations
that can be drawn from the data are merely theoretical and cannot
be proven. This isn’t his fault, its simply the nature of proof
and evidence. There is no way one can extrapolate the
motivations of thousands of individuals by studying number data
and one doesn’t have the resources to ask all of these people
about their motivations. One can only manufacture logical
explanations for the data.
This isn’t a bad thing. You can learn a lot by thinking in that
manner. My guess is that people do not lose money in the markets
because they are stupid or suffer from a lack of knowledge.
Remember that most mutual funds also underperform the stock
market. I believe the primary difference between winners and
losers is psychological. Winners and losers are presented with
the same set of information, however the winners take different
actions. What guides their actions? From my own history of
losing and then making a lot of money in the stock market and
study of general and trading psychology I’ll try to come up with
some explanations. I believe that the actions of losing traders
are guided by fantasy and a fear of losing while winning traders
are guided by confidence. Without the proper mindset and
attitude you cannot make money in the stock market. It’s not a
guarantee to being successful, but it’s a prerequisite. However,
the stock market is an environment that makes it difficult for
most people to obtain this proper mindset, let alone maintain it.
reality -> senses -> beliefs -> identification -> motivation ->
actions
The human mind gathers information about the outside world
through the uses of it’s senses. It recognizes the information
and then processes it. It then identifies it and responds to it
with a whole host of beliefs, unconscious and subconscious.
Based upon a person’s motivations and interpretations of what is
taking place he carries out an action. The key is that actions
that people take are based upon their own set of associations
with what is going on in the world outside of them. These
associations are based upon past experiences and a person’s
beliefs about himself and the task at hand. The world consists
of inputs that make people feel and they respond.
To relate this to trading, winning traders and losing traders
experience the trading environment differently. It makes them
feel different and as a result their actions consistently vary.
To relate this to psychology they interpret the market
differently because they have a separate belief system in the way
that they see themselves relative to the stock market.
Let’s list these beliefs and actions below:
Belief statements that different traders can make:
Winning Traders
The markets provide an opportunity
The markets exist to give me profits
If I get stopped out then I have to reevaluate the trade
If the market doesn’t do what I expect then I must reconsider
I’ll take one trade at a time.
I don’t have to be perfect, I just have to do my best.
Money is not that important
Losing is part of the process of making money
Trading is a game, I know I can win
Every setback provides me with new market information
I can wait for an opportunity to come
Losing Traders
I must be in the market now
If I lose on this trade I am a loser
If I wait for my trading rules I’ll miss out
If I get stopped out I have bad luck
I can’t lose money
The market makers got me again
I’m an idiot, how could I lose money
What will they think when I tell them I lost money on this one?
The stock market is rigged
It’s impossible to get a good fill
I cannot take a loss
If I take my profit then I am right
These different beliefs create different characteristics of
winning and losing traders:
Winners:
Get pleasure from trading the market as an end in itself
Not motivated primarily by money
Confident that they can make money in the market
Not afraid to take a loss
Patient - waits for opportunities
Uses a highly planned strategy
Is well prepared, done his homework
Measures the risk/reward ratio of every trade
Losing Traders:
Never define a loss
Locked into a narrow belief system
Hesitate to make a trade
Do not stick to a system
Trade by whim
Trade by emotion
Have no consistent strategy
Do not practice risk management
more interested in proving themselves right then being a success
Financial markets are structured in such a way that make it very
difficult for someone to approach them with a confident psyche,
that is why it is so difficult for most people to make money
trading them. Almost all environments - the workplace, family,
friends - provide external forces that limit a person’s behavior.
They provide a set of rules of what is right and wrong and what
actions are to be rewarded or punished. This is not true for the
stock market.
The stock market does not care if you make or lose money. The
market has no control over you. Since the market does not exert
any external control over your actions you have to fashion your
own system of rules and have the discipline to obey them in order
to be successful. No one else will do it for you. You have to
have the confidence to take this responsibility yourself. In
order to succeed takes enormous self control and discipline.
Most people cannot take this approach. Instead they construct a
fantasy in which the market provides them with future riches.
They transplant these fantasies on to the individual stocks that
they purchase and have difficulty confronting the reality of
being wrong. When events don’t match their illusions they simply
ignore them. If a stock they bought drops below their purchase
price they refuse to reject the fantasy that their decision to
purchase the stock will make them money and instead convince
themselves that it is a winner that merely isn’t in favor yet.
However, stocks do not make successful traders money. They do it
themselves. Instead of believing in the power of stocks, they
believe in the viability of their own trading strategy. They
have faith that their own disciplined interaction with the stock
market will make them money and not the other way around. The
decision making freedom the stock market gives ruins most active
investors, but handsomely rewards the few prudent traders.
As I said earlier it takes extreme confidence to execute a well
planned trading strategy and most people cannot find it. Instead,
they often experience intense anxiety in the market. They may
come to believe that the markets are rigged against them. The
market doesn’t cause this. It’s their lack of strategy that
does.
What one has to do to move from a fear stricken psyche to one
capable of building enough confidence to make money in the market
is to first believe in oneself and develop a strategy that
consists of strict money management techniques. I’ll discuss how
I have done this later. But, once you have a strategy in place
you have to have the fortitude to continue to believe in it when
you suffer losing trades. Losses are a part of the game. The
way to make money is to accept them and to use money management
techniques to keep your winners larger than your losers.
You have to move away from a mindset that stocks will make you
rich and believe that your trading method will make you money.
Then you must come to realize and hold the belief that being
right or wrong on each individual trade does not matter. You
have to be able to move through the adversity of losing trades
and hold the faith that you will make money in the long run.
This is why people find it so difficult. People focus too much on
the individual trade and hold unrealistic fantasies and cannot
live up the decisions that go wrong. The worst ones take it
personally. Most never understand what is required to succeed. - from swingtradingonline.com |
