The capability of controlling your emotions while trading will enable you to act decisively in trading.
Don’t get emotionally attached to your trades. As one trader put it, “I don’t own stocks. I just rent them… think of how you feel about a house. When you own a house, you feel different about it… Well, the same thing is true when you buy a stock. Unfortunately, most people think they own them. Conversely, I don’t get emotional and remind myself to treat stocks as if it’s my money market account. In other words, stocks is one of the money market trading instruments where you choose to invest or trade in a period of time. Sometimes it’s ten minutes, sometimes it’s an hour, and sometimes it’s five hours. Maybe it’s five years, but I try not to get to where ‘stocks’ mean anything to me other than a number.” It’s vital to look at the stocks you buy as objectively as possible. But it can be difficult at times to avoid having an emotional attachment to stocks. We spend time studying the factors that move the prices of the stocks we follow most closely, and it’s natural to develop favorites. We must not get attached, however. Owning stocks is merely a means to making profits, nothing more.
Judging a book by its cover
In behavioral economics, there is a phenomenon called the “money illusion.” In summary, people often use their stereotypes and emotions to bias their decisions when it comes to assessing the value of stocks, currencies, or goods. Rather than carefully determining the “real” value of stocks, currencies, or goods, we base our judgments on emotional attachments and stereotypes.
When forecasting whether a stock price will increase, for example, we view certain sectors or commodities as “hot” or “up and coming,” and we may base our forecasts on these attitudes, rather than concrete facts and objective analysis of the “real” value of the stock. A study by Dr. Donald MacGregor and colleagues at Decision Research illustrates how traders may tend to use emotional stereotypes to bias their forecasts. A group of advanced business students enrolled in a securities analysis course was asked to make decisions regarding a set of industry groups, such as computer software, pharmaceuticals, railroads, on the New York Stock Exchange. Unknown to the participants, half of the industry groups consisted of high performing stocks (greater than 20% return) while the other half consisted of low performing stocks. Participants rated each industry group on whether they had a positive (for example, value, activity, and strength) versus negative image. They were also asked to predict the rate of return for each industry group. Industry groups that were rated by participants more positively were viewed as having the highest return. But a company’s image had no relation to actual market performance, as measured by weighted average returns for the industry group. In other words, participants allowed their beliefs and emotional stereotypes that a particular industry group had an “image” of strength, growth, and profit to bias their forecasts.
How often emotional trading affects our trading plans
A similar judgment bias occurs when evaluating the value of goods. For example, in a classic study where children were asked to compare the size of coins to cardboard disks, which were of the exact same size, the size of coins were judged as larger. When we see money, even at a young age, it tends to bias our judgment. We develop an early attachment to money and imbue it with significance.
Money carries emotional significance, and we naturally allow the value we place on money to bias our decisions. Several studies have shown that people tend to care more about specific dollar amounts than buying power. For example, studies have shown that during times of extreme inflation, people would prefer to receive a $1,000 raise, even if in reality it would correspond with a $2,000 increase in prices in the next year, rather than having the option of no raise under conditions of minimal inflation. Our emotional stereotypes tend to bias our economic judgments. Unless we make a careful analysis of the value of stocks, commodities, or currencies, our preconceived emotional stereotypes may bias our opinions.
Researchers Tyszka and Przybyszewski (2006) conducted a study in Europe at a time when the euro was seen as weaker than the U.S. dollar. When participants were asked to judge how expensive various goods were, they judged goods in which the prices were expressed in U.S. dollars as more valuable than the same goods at the same prices but expressed in euros. The effect reversed at a later time when the U.S. dollar was seen as weaker than the euro. It’s natural to allow our biases to cloud our judgment, but a good or service has the same value whether expressed in terms of dollars, euros, or lira. (Note that participants were not asked to buy euros or dollars, but to merely judge the values of goods with a price expressed in euros or dollars.)
Consistent profitable trades come from objective trading decisions
When it comes to making judgments involving money, it is easy to allow our preconceived ideas to bias our opinions. At a very early age, we learn that money can be exchanged for goods and services that we find valuable. Throughout our lives, money has been associated with security, safety and happiness. The media constantly bombards us with the idea that money is security. The more money we have, the more security we will feel. It’s hard to shake these preconceptions and learn to look at stocks objectively. Many traders are attracted to trading because of powerful images of wealth. The more money they make, the more status and freedom they believe they will gain. Although it is natural to equate money and profits with security, doing so can create biases that adversely impact trading decisions. Profitable trading demands a logical, unbiased mindset. It’s vital that you try to objectify your trades as much as possible.
Achieving emotional stability while trading
Taking the emotional attachments out of trading takes practice, but with a little preparation and planning, you can learn to trade objectively and effortlessly. Perhaps the most important strategy you can take is to limit your risk on a given trade and trade with money that you can afford to lose. By limiting your risk to a relatively small percentage of your trading capital, you will know that should the worst-case scenario occur, you can handle it easily. You will not be trading with “scared money,” and you will feel more at ease. If you feel that losing the stake on a given trade has little real personal significance, you will be able to treat the trade with little emotion. It’s easier to control fear when there is truly little to fear. It’s also important to view profits and losses in terms of percentages. Rather than focus on concrete images of the actual dollars you are trading, which you will surely associate with what you can purchase with the money (such as car payments, groceries, or school tuition), you’ll be able to more objectively focus on the trade if you view profits and losses as abstractly as possible, as merely points or abstract digits.
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