Behavioral Finance Tips for Successful Trading
In 1912, American author George Charles Selden pooled his decades of research into a book that would become ground breaking – the Psychology of the Stock Market.
At the time, the prevailing view of market experts was that investor buying and selling behavior and the resultant ebb and flow of stock prices was essentially rational. Selden challenged that view positing that human emotions were a significant determinant of investor behavior.
By the 1990’s the field of behavioral finance — or behavioral economics — born from his research had become a mainstay of investment theory and practice.
One of the primary findings of behavioral finance proponents is the need for setting goals. Psychology tells us goals are a key factor driving human behavior. Ask most market participants what their goal is for investing in the market, the virtually universal response is “to make money.”
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Is “making money” a goal that would pass muster with the leading thinkings in contemporary business theory and practice? Experts there and in the field of behavioral finance would recommend the SMART goal strategy.
Set Realistic Goals
“Making Money” fails the SMART goal test on every measure:
- It is not SPECIFIC. How much is enough? What sources will be used?
- It is not MEASURABLE. Have you reached your goal if you have made Ten dollars? One hundred dollars? One Thousand dollars?
- It is not ACHEIVABLE. Without a plan of action, a broadly general goal is not likely to be achieved
- It is not RELEVANT without being place in the context of the investors larger strategy.
- It is not TIME BOUND without dates and deadlines.
The biggest benefit of adopting a SMART goal strategy is that it forces the creation of specific plans to achieve specific goals in a specific time frame. Behavioral finance has taught us a well-developed plan is the North Star of investing.
Control Your Emotions
Investors can find themselves whipsawed by emotions like fear and greed , two emotions identified by behavioral finance as having significant impact on investor behavior. There is a herd mentality in markets that can drive investors to follow the crowd into buying and selling at the wrong times. Loss aversion is another significant contribution behavioral finance has made to the world of investing. Studies have shown the emotional reaction to a losing trading exceeds the reaction to a similar winning trade. The fear of losing 15% is a more powerful motivator than the pleasure of a 15% winning trade. Loss aversion can be so powerful it leads some investors to sell winning stocks to balance the loss from a stock they are sure will recover some day.
Fear, greed, and loss aversion are emotions that can be controlled by sticking to a well-developed investing plan. Planning, however, is fruitless for investors who fail to follow the second part of a well-known adage about planning – Plan your Work and Work your Plan.
An investing plan with parameters for acceptable losses, desirable gains, and other factors can be a refuge for investors reluctant to sell their losers and ride their winning trades.
Have Patience
Markets can move with incredible speed in either direction when the herd mentality captures too many market participants. If the herd is dumping a stock, the fear of loss can move an investor to follow the crowd and sell in a panic, as can greed leading to buying a “hot” stock simply because the herd is buying.
Patience is not easy to come by if investors let their emotions trump their plans. A well thought out plan should include the paraments for buying and selling, regardless of what the market is doing. In today’s world, investors are deluged with “noise” – information not relevant to their plan – and “signal” – relevant information for investment decisions.
Much of market noise comes from the obsession with market timing. Short term price movements and sensational company news or unfounded rumours are often irrelevant to the long-term performance of a stock. Patience requires thinking long term and having the patience to avoid panicked moves, something that sticking with the investment plan can help accomplish.
Learn From Your Trades – Mistakes and Successes
No plan is perfect. Mistakes will be made. Keeping an objective journal of trading decisions allows investors to learn from mistakes.
Research has shown many retail investors do not make money in the stock market, with emotional decision making cited as the leading cause. Honesty in assessing trading mistakes can uncover patterns that then can be avoided in future trades.
Succumbing to fear and greed and trades driven by loss aversion can only be remedied by brutal honesty in mistakes made in a trading journal. Investors can also fall prey to following hot trends and “spruiking” and hype from some sources.
Research found the worst performance among retail investors comes from day traders. Trading frequency characteristic of day traders can be costly. Some studies on the performance of day traders suggest between 80% and 90% lose money and discontinue day trading within a few years.
Although common sense might suggest more can be learned from trading mistakes than from successful trades, identifying the components of successful trades are more likely to be repeated than if what went into a successful trade remains undocumented, losing the opportunity to identify patterns in both winning and losing trades.
Ensure Regular Breaks
Serious investing in stock markets is hard, requiring significant time spent developing a trading plan and the research required to stay up to date on market and economic conditions. If it were easy, more people would do it and more people would make money at it.
Taking a break is wise advice in virtually all human activities that require breaking into a sweat, either physically or mentally. Stock market investing is no exception. Timing the market is something that makes taking breaks difficult. Investors who feel compelled to stay on top of the constant barrage of financial news, regardless of whether the news be “noise” or signal are more likely to revert to emotional decision making.
Most trading platforms allow you to set text or email alerts on price movements or news on stocks you designate according to the parameters chosen.
Valuable insights from the field of psychology have made their way into the world of share market investing. Research finds significant risks to retail investors who allow emotions like fear and greed to influence their buying and selling behavior.
Establishing a detailed trading plan, specifying targeted investments, entry and exit points, and ideal holding times can keep emotions at bay, as long as investors follow the plan. Keeping a trading journal allows investors to learn from both mistakes and successes.
