7 Psychological Traps Every Trader Must Face
Related: Best Stock Picking Advisors, Motley Fool Stock Advisor Review, Investment Advice Sites, How to start investing in the stock market
There are enemies we know about in trading, such as bogus information, outlandish promises of wealth, and financial risk. Once aware of these threats, we can take steps to monitor outside information and protect ourselves. Yet some of the greatest risks we face as traders are from within. The market may be blamed, but it is how we react in response to the market that caused the huge trading loss or missed opportunity. Here are seven psychological traps that are prevalent in trading; becoming aware of them is the first step toward improving, and the next step involves creating a plan to overcome these traps in real-time.
Exposure bias is when we form an opinion based on the most readily available information, without checking to see if the information is correct. A news anchor may make a witty financial comment that goes viral, and in turn becomes “common knowledge.” Traders then act on this information believing they are doing a good thing, yet the original source of the information may have been inaccurate. Just because you hear something often, doesn’t mean it is true.
Because so much news is available—we are overexposed to it—a trader may believed they need more and more information to be an effective trader. This is an exposure bias. Nothing dictates that more information will make you a better trader. In fact, protecting yourself from the many biases inherent in the comments of others may actually makes you a better trader, because your trades will only be based on your own convictions, strategy and research.
Confirmation bias is the tendency to draw a conclusion first, and then rationalize the decision after. Humans have a natural tendency to do this. Instead of testing out a market strategy and spending several months in a demo account to make sure it is profitable, most traders jump right in, assuming the strategy works, betting real money on it. They made the conclusion before getting the facts. No matter what happens, the trader can rationalize the choice; the strategy works and they are genius, or the strategy fails and they have the excuse that the strategy wasn’t tested.
The only way out of this trap is to keep an open mind when first exposed to something new. Attempt to verify the information before acting on it. Seek evidence that confirms and denies your suspicions, and then draw a conclusion based on all the evidence.
As humans, we have a tendency to extrapolate what is happening right now into the future. If the price of a stock is sky rocketing, our decisions tend to be based on the idea that it will continue to sky rocket. Taking a step back will of course reveal that stocks always move in a trend-pullback-trend-pullback fashion. Yet in the moment, traders often forget this and end up chasing the price.
While prices may continue to run in one direction for some time, trading requires rules that dictate when to get in and when to get out. By always chasing the price these rules are likely to be violated.
There is a reason funds are required to disclose “Past performance is not indicative of future results.” Conditions change, and chasing trends is a sure way to get caught when they do. Establish rules for when to get in, and if you miss your entry point, don’t chase the price. Another opportunity always comes along.
Confidence in what you are doing is a requirement for traders; without it you can become easily rattled by see-sawing markets. Overconfidence is a killer though.
Believing so strongly in a trade that you ignore contrary factors, or are willing to risk everything on a trade you believed in, is how overconfidence presents itself in the markets. You can be confident and still admit you are wrong. The overconfident person refuses to admit they are wrong and ends up paying the price. Usually they hold losing trades too long, believing they are smarter than the market and the price will eventually make them whole. They may also hold winners too long, letting it turn into a loss because it didn’t give them the profit they expected.
Remain open to new information, even if it goes against your beliefs about a position. Ideally, follow a plan that establishes when you will get into a position, what you will risk, and when you will get out. This way, overconfidence won’t affect you, because you have a plan for how you will trade, which isn’t based on emotion.
Loss aversion is the tendency to do whatever it takes to avoid a loss. Losses are painful, so we stay in toxic relationships to avoid the pain of leaving, and we stay in losing trades to avoid the pain of accepting the loss. The irony is that in both these cases the damage has already been done, we just haven’t accepted the loss yet. Usually these situations only get worse, and if it becomes a pattern the trading account is likely to be drained. Even if we avoid a couple of big losses by hanging on, and the price comes back to produce a profit, if we do this repeatedly eventually one of those trades is going to keep going against us until it is too late to salvage.
The ideal way to handle the situation is to set a risk limit on each trade. Once the price reaches that risk limit exit the trade … and never deviate from the rule.
Paradox of Choice
Choice is good, right? Maybe not as good as we think. Too many choices can actually lead to confusion and can make it difficult to come to a conclusion. Stock traders frequently experience this. There are so many stocks with big moves each day that you can drive yourself crazy trying to keep up with them all. Trying to follow too many stocks can actually lead to reduced performance because the more time you spend examining your choices the more likely it is you will miss trades or make trading errors; your focus is not on trading, it is on your choices.
Limit your universe of choices. Set criteria for what you will trade, and then only trade a couple stocks each week that meet the criteria. Alternatively, only trade one very active stock all the time. It is less stressful and with a defined number of trading choices it will be easier to monitor and find trading opportunities.
"Popular Prescription" Bias
A popular prescription, as it applies to knowledge, is a concise phrase—often a quote—that sounds great but holds little usable information. Traders latch on to these phrases because they are easy to remember. The problem is that the phrase is general in nature, and not specifically usable by the trader. An example is “The trend is your friend.” It sounds like sage advice, until you begin to question what it means. In order to have relevance you must determine how you will define a trend, and you still need to answer the question of how will enter and exit that trend?
Trading is a calculated endeavor, which requires more than simply remembering a few one-liners. Monitor what you hear, and if sounds good, dig deeper into how you can actually apply the advice. “The trend is your friend” isn’t usable information, but digging deeper and putting in some work to fill in the holes could lead to a good trend-following strategy.
The Bottom Line
The external world bombards us with information in the form of news reports and price changes. It is easy to point the finger at these external events and blame them for our trading mishaps, but it is our own psychology that allows us to fall victim in the first place. These psychological traps represent some of the “devils within” that need to be understood, addressed and marginalized in order to really succeed as a trader. Take a hard look and spot the biases you are most prone to. Then, create a plan for how you will address these issues. Accept the bias and follow your plan to reduce the power these psychological traps have over your trading and life.
Quotes of the Day:
More Stock Market Resources: