This blog is in collaboration with Aatman - The Psychology Cub of PDEU
Who doesn't like making money? In the ongoing era, anybody with capital can invest. Stock trading, the activity of buying and selling stocks in the market largely aimed at achieving profits is flourishing. It can be done online, with just a few clicks making it extensively accessible. Our instinct while watching cinematic content like "The Wolf of Wall Street" or "Scam 1992" is wanting to earn humongous profits. Theoretically, the thought process that goes behind trading is very meticulous. One has to be alert and watchful because there is a lot at stake, quite literally.
It is often believed that an activity which requires scrupulous attention and concentration results in highly rational decisions and leaves no room for emotions. But it is quite the opposite. More often than not, our emotions and our cognition are two key factors that take charge of our actions. Emotions which are extremely necessary for human relationships are not quite an ideal fit for finance. Considering that we humans are highly neurological and internal, emotions impel us to take actions which have social and external impacts on us.
So the question arises, how do emotions exactly affect a trader?
Emotions are our neurological reactions to internal or external stimuli. Every individual reacts differently to different emotions but when it comes to trading, there exist some common reactions shown by traders in response to emotions that make them or break them.
Fear, Greed, Regret and Hope are the emotions that are known to us and are experienced by us in daily life. Coming to Trading in specific, Fear is often a performance inhibitor. In bearish markets, fear results in panic among traders, it impels them to act irrationally. It is usually a threat to profits and potential trading opportunities.
The famous Wall Street expression - “Pigs get slaughtered.” portrays the emotion of Greed amongst traders. An example of the same is shown in the Indian TV Series “Scam 1992”. Manu Manek suffered losses mainly due to his greed. Greed often occurs after periods of sustained success, it leads to overconfidence and aggressive risk-taking. During the final phase of bull markets, greed becomes the dominant force and traders are seduced by the prospect of getting rich quickly.
Regret is a more complex emotion. It often causes traders to buy shares at inflated prices, after initially missing out on, or a foregone opportunity due to a previous bad experience. However, the regret theory suggests that traders anticipate regretting making the wrong decision, which can either make them risk-averse or drive them to take higher risks.
We can not talk about trading without the existence of Hope because what is life (or trading) without a glimmer of hope? To one's surprise, it is noted that hope is one of the most dangerous emotions when it comes to trading. Hope is what holds one in a losing trade after having hit the stop, or prevents one from gaining profits on a winning trade. It’s what instigates traders to make bad decisions in the hope of recouping past losses. It is also the main reason people trade with money they don't actually have. Revisiting the previously mentioned example of "Scam 1992”, hope is what made Harshad Mehta take risks higher than he could afford, which eventually led him to prison.
But emotions are not the only factor influencing trading decisions. Trading biases are a thing too. Biases refer to our inclination towards a certain opinion, object or a person. When it comes to trading, some of the most frequent biases are herd bias, disposition bias and anchoring bias.
Herd bias depicts herd mentality. This suggests that a trader takes decisions based on what other people are doing. If maximum people are selling their stocks, that's exactly what the trader will do without considering the consequences.
Disposition bias happens when people believe that their current situation won't stay the same. This happens in two forms. In the first case, people think that their winning trajectory won't last long and hence they quit too early and in the second case, they stick to their losing stocks for too long because they believe that the losing streak might end soon which is similar to Gambler’s and Hot Hand Fallacy, mainly due to the trader not being able to separate trade and luck/hope.
Anchoring bias is another frequent and unavoidable bias developed by traders. Here, the traders tend to stick to the first piece of information or data that was given to them and focus only on the same. They base their decisions on this information and compare the subsequent decisions on the basis of the first piece of information. This bias makes them stay with losing stocks for too long with a hope that they will return to their original position and earn profits.
How should one avoid these obstacles and trade wisely?
It is quite impossible to trade by completely removing or being indifferent to our emotions and biases because they’re tied up to almost everything we do. But what we can control is the way we recognise and respond to them. The more aware we are about them, the better is our trading psychology.
Keeping a trade journal can help monitor emotions and understand the psychological state. Moreover, taking regular breaks and time-outs can alleviate the unconscious influence of emotions and can help manage the situation with a rational and composed mind. Making daily trading plans and constantly trying to be more self-aware is the key to move forward and enhance trading psychology.
At the end of the day, better said, before the ending bell, the crux of trading psychology is that it is normal to experience emotions and biases. Accepting them isn’t a weakness it is in fact a strength. It’s when you can be truly honest about what you’re feeling and why that you can learn from your losses and improve your skills as a trader (and a person).
“You can’t always control your emotions. However, the capability to perceive and recognise them and not let them rule your decisions can take your trading experience to the next level.”
Written by: Maanya Shah SLS'19 (Team Aatman)
Akanksha Guha SLS'20 (Team Aatman)
Edited by: Anika Dadhich SLS'19 (Team Aatman)
Ushma Doshi SLS'18 (Team BullsandBears)
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