Psychology
6 IRRATIONAL BEHAVIOR AND THINKING PATTERNS - THINKING CLEARLY !Hello everybody and welcome,
I hope you'll have a pleasant time reading this. And I also hope it'll somehow be useful to you.
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Let's face it, your biggest enemy in trading is not the market, not the hedge funds, not the banks, it's you. Thinking clearly is one of the hardest things to do when trading/investing.
We've all, at least once, done something and asked ourselves afterwards, "why did I do this ?" or "how didn't I see this" ? Did you know that this is called the "Hindsight bias" ? Yes, it's a well-known phenomenon in psychology.
Before we begin, let me explain the diagram. Developing clear thinking takes time. You'll find it very hard at first, but as time goes by, if you keep your focus on it, you'll notice your performance increasing exponentially (this also applies to your life in general !).
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1. Confirmation bias
The confirmation bias, is the distortion of information to make sure that it fits our beliefs. Let's think about it that way : if you think that the world is an awful place, you'll find facts to back your belief about the world. What happens when you encounter a fact that denies your belief ? You either ignore it or distort it in order to make it fit your belief.
It's about the same thing when you're trading. Sometimes, especially new traders, hold bags, meaning that they hold on to losing positions for a long time, hoping for a recovery. No matter what, the trader will find himself putting more weight on the information that confirm his belief (that he's right) and will ignore the information that refutes it (that he's wrong and should sell).
In order to avoid the confirmation bias, you need to weigh every new information the same way .
2. Hindsight bias
The hindsight bias, is directly correlated to the confirmation bias. We tend to understand things better in hindsight than we do in the present moment. To take the previous example of the trader that holds bags a little further : what happens when the trader decides to cut his losses ? He immediately says : "Oh, all the information I had indicated a clear downtrend, why didn't I cut my losses earlier ?". The hindsight bias. In hindsight, everything appears to make sense.
In Trading, the best way to avoid this bias, is to react to the market information that's available to you, rather than trying to predict it or to hope for something to happen. In other words, when you have an edge, you trade your edge and you remain open to any information the market gives you, be it information that confirms or invalidates your initial belief.
3. Loss aversion
We feel better losing nothing than winning something - say hello to loss aversion. Overall, humans are more sensitive to negative things than to positive things. Think about how much we complain. Sometimes, it's justified, but often it isn't. We complain about things we don't have, but omit to be grateful for everything we have.
In trading, loss aversion, is the pattern that makes us hold on to a losing position for a long time. After all, an unrealised loss is less painful than a realised one. To avoid loss aversion, you have to work on your mindset and start thinking in probabilities.
4. Outcome bias
This is another very, very important psychological trait that messes with our trading. Human beings tend to judge a decision by its outcome, rather than gauging the decision process. In the best case scenario, you have an edge and you act on that edge every single time you see it appearing on a chart.
The problem is, because trading is all about probabilities, sometimes, your edge won't work. Does this have something to do with the process ? Absolutely not, it's just how trading works. But, when you aren't aware of it, you start questioning your trading strategy, even though, the outcome is not correlated with the process. Just be aware that the outcome is not a reflection of the process .
5. Action bias
Whenever we do something to compensate for our inaction, we fall for the action bias. We rather do something useless than nothing at all. If you watch football, you've probably witnessed this bias a lot of times. When the opposing team shoots a penalty, the goalkeeper, either dives left or right, even if chances are that the opposing player shoots right in the middle. Why ? Well, diving looks way better than just standing still, whatever the result is.
As Jesse Livermore would say, " Money is made by sitting, not trading ". Considering this bias, for us human beings, it is hard to sit and do nothing. Just think about what you do when you have to wait, be it in a waiting room or at the bus stop. This could be an explanation why most traders fail. They struggle letting their trades unfold and get caught into thinking that their inaction is harmful. Eventually, they end up overtrading, taking trades they otherwise wouldn't, to avoid inaction.
"All of humanity's problems stem from man's inability to sit quietly in a room alone", Blaise Pascal.
6. Overconfidence effect
Overconfidence is a very evil trait to trading. When we are overconfident, we tend to overestimate our knowledge and take bigger risks. Financial markets are unforgivable with overconfidence. Markets really are unpredictable, therefore we shouldn't even try to predict them.
We need to go with the opporunities that the markets make available to us . The best traders are aware of it, therefore they try to be humble and respect the markets. As an example, we could imagine a trader that is on a 5-trade winning streak. He feels great, he feels invincible. What happens ? He takes bigger risks and one day he'll inevitably issue a huge loss.
Why Beginners Lose Money Even in an UptrendIf you like this analysis, please make sure to like the post!
I would also appreciate it if you could leave a comment below with some original insight.
In this post, i'll be focusing on the psychology aspect of trading and investing that most people overlook.
Contrary to common belief, in my personal opinion, understanding a trader and investor's own psychology is significantly more important than educating oneself on trading techniques and learning how to read financials.
'Buy low sell high' is the motto. As simple as it sounds, why do most people lose money trading or investing?
There are four major mistakes that most beginners make:
1. Excessive Confidence
This stems from the idea that people think of themselves as special. They think they can 'crack the code' in the stock market that 99.9% of people fail to, and eventually make a living trading and investing. However, taking into consideration the fact that more people lose money in the market, this form of wishful thinking is the same mentality as going into a casino feeling lucky. You may actually get lucky and win big the first few times, but in the end, the house always wins.
2. Distorted Judgements
While simplicity is key, the approach most beginners make in trading and investing are too simplistic, to the extend where it's hard to even call it a trading logic or reason to invest. They spot a few reoccurring patterns within the market, and this is almost as if they discovered fire. It doesn't take long to realize that the "pattern" they spotted was never based on any solid reasoning, or worse, wasn't even a pattern at all in the first place.
3. Herding Behavior
The fundamentals of this is also deeply rooted in a gambling mindset. Beginners are attracted to the idea of a single trade or investment that will make them a millionaire. However, they fail to realize that there is no such thing. Trading and investing is nothing like winning the lottery. It's about making consistent profits that compound throughout time. While people should definitely look for assets that have high liquidity and some volatility , the get-rich-quick mentality drags irrational beginners into overextended/overbought stocks that eventually drop drastically.
4. Risk Aversion
Risk aversion is a psychological trait embedded within all of mankind's DNA. Winning is fun, but we can't tolerate losing. We tend to avoid risk, even when the potential reward is worth pursuing. As such, many beginners take extremely small amounts of profits, in fear that they might close their position at a loss, trading with a terrible risk reward ratio. In the long run, their willingness to not take any risks leads to losses.
Depending on the price action, they also go through seven phases of psychological stages:
- Anxiety
- Interest
- Confidence
- Greed
- Doubt
- Concern
- Regret
As we can see in the chart for the S&P500 (SPX) , there are price points at which beginners would buy during their 'confidence' phase, and sell during their 'concern' phase.
As a result, they would be losing money even when the market moves in an upward trend.
Even when the market is at a clear uptrend, it goes through phases of impulse moves, and corrective moves.
However, as beginners are swayed away by their emotions, they fail to recognize the overall trend, resulting in them buying high and selling low .
Conclusion
The most important thing that beginners need to realize before they start trading or investing is that human beings are emotional beings, and as a result, they are not different from the rest of the people in the market. All successful traders and investors throughout history have had superb meta-cognition. They understand their own psychology, as well as that of other participants in the market, allowing them to make rational decisions with patience, rather than hasty decisions based on emotions.
Can a Strategy be bought?To be successful as a trader, you have to understand that this activity is a continuous battle for survival. If you don't think like a warrior, you will have a very short life as a trader.
More than eighty percent of retail and intraday traders will kill their accounts in their first three months. The most successful traders learn the painful and costly rules of survival in the markets through trial and error.
The word "strategy" comes from the ancient Greek term stratēgía ("office of the general, command, generalate"), from stratēgós ("the leader or commander of an army, a general"), from stratós ("army") + ágō ("I lead, I conduct"). In other words, it is a matter of "thinking like a general".
The most important book on this subject, the Sunzi Bingfa , poorly translated as "The Art of War", deals with planning and strategic analysis. The fact that this book deals with strategy, not war, explains why its methods are perfectly applicable to the planning of market operations and to any other activity that requires foresight and analysis.
According to its author, the Chinese general and philosopher Sun Wu , known as Sunzi (Master Sun) or Sun tzu, success is not for the strongest or the most aggressive, but for those who best understand their situation and what their alternatives really are. By studying and understanding the strategic framework proposed by Sunzi, you will be able to analyze almost instantaneously any competitive situation in the markets, detect opportunities and make appropriate decisions.
This contribution and the following ones are a tribute to the millenary wisdom of this classic work and a gift to those novice or expert traders who, like me, were defeated before the markets for not having a Strategist mentality.
Dario van Krauser
Strategists Trader