Emotions can burn... your money

I am a believer in behavioural finance, a discipline that assumes humans are not rational.

We are not the optimization-seeking decision-makers that traditional economics taught us. We act on emotion and thus make irrational decisions without full information.

Trading is a stressful activity and stress can trigger a cascade of reactions known as the "fight-or-flight" response. This survival mechanism, enables people to react quickly to life-threatening situations but it can also make us overreact to stressors that are not life-threatening, such as work pressure.

Our human nature makes us dive into things when they are doing great and run from them when they are not. But as a trader you must be able to do exactly the opposite if needed.

If you want to start trading you must have a trading strategy, but you must also be prepared to a very cruel reality: that strategy will work well under some circumstances and fail in others. With markets facing such high volatility times you must be able to adjust, keeping in mind that the acute stress response system that is embedded?in your DNA can make you run when you don't have to.

There is a huge difference between adapting (your strategy) and shifting (to a completely different strategy).?

When trading, there are 3 common behavioral mistakes you must be aware of so you can pragmatically address them:

1. Overconfidence

No matter how proficient you are in technical analysis you cannot predict markets. You sit at your laptop, look at the charts and trend lines, and you make assumptions based in previous patterns. Chances are you’ll probably only be right half the time. The day may start as you expected, but suddenly a headline comes up, a new event affects the course of action, and the trend reverses unexpectedly. Sometimes reversals are just temporary, they correspond to a price adjustment or a sudden price move caused by a large volume negotiation. If you keep on correcting your positions you will overtrade, and by doing that you’ll increase your risk of falling because emotions will take control.

2. Confirmation bias

We tend to seek for information that supports our previously held ideas and beliefs and ignore information that contradicts it. Such bias helps to explain why investors do not always behave rationally and ultimately it can help us understand markets' inefficiency. Bulls tend to remain bullish and bears tend to remain bearish regardless of what is happening in the market.

I keep a trading journal and analyse trades after exit – especially those where I lost money – so I can spot the decisions where I was deceived by my confirmation bias. My best advise is that you create a checklist with a multiple validation criteria to corroborate each decision. The process will take longer but chances are that the time spent will save you money, since a triple validation forces a deeper analysis and prevents you from making the same mistakes over and over.?

3. Loss aversion bias

Nobel prize winning psychologist and economist Daniel Kahneman?found that people feel the pain of a loss twice as much as they feel the pleasure of a similar gain. Meaning that when you experience a loss, the disillusion will last a lot longer than the thrill you feel when you experience a gain. Loss aversion refers to an individual’s tendency to prefer avoiding losses to acquiring equivalent gains.?

In my previous article I explained that sometimes we are trapped by our failures in the impostor syndrome, that makes us doubt ourselves and ultimately paralyses our actions. Just like a child that is learning how to ride a bicycle must jump right into it after a fall, so should an investor continue trading after a bad trade, as long as he/she is able to keep the focus, mind the strategy and stick to the stop loss mechanism that prevents overexposure.

These behaviors that can?make you burn in trading can also mislead you in your life, regardless the professional activity you have or your risk-taking features.

“Know thyself” is a teaching inscribed on the forecourt of the Temple of Apollo at Delphi. Greek philosophers believed self-knowledge was the highest form of knowledge and indeed you have to know yourself and identify your triggers to become a good trader.

Knowing thyself can be one of the most difficult thing to do. Yet, self-awareness, the ability to see ourselves clearly, understanding who we are, how others see us and how we fit into the world is the most powerful of all strengths.

If you wish to become a trader start by a deliberate, conscious introspection to better understand how you think and how you react. If you want any assistance in the process I can help you get started.