We are all human beings, this is what makes us all equal. We have emotions which can hinder our control over everything we do in a positive and negative way. Emotions which we all have include, fear, greed, vanity, pride, hope, jealousy, ego and denial. These emotions, if not controlled can impact the way we invest, more importantly the decisions that we make surrounding our investments.
Your aim in the market should be to make as much profit as you can, while minimising the amount of risk you take. Doing this is sometimes easier said than done. We all value money and invest time and effort into each investment decision. What would happen if your investment started to go in the opposite direction to which you originally intended? How would you begin to feel?
Most undisciplined investors would watch as the value of their investment shrinks before their eyes. It's never easy to watch hard earned money disappear! Human emotion can cloud the decision making process at this stage and will commonly hinder the performance of many investors. Emotion persuades the trader to hold onto the position in the hope that it will one day come good, after all, you always hear that stocks go up in the long term. The belief will always remain strong that the position will one day become a winner!
This is an example of Loss Aversion. Humans place more value on a loss than on a gain, by this we simply mean, humans suffer almost twice as much pain losing $1 as they would feel in pleasure gaining $1 (Kahneman and Tversky, 1991). This is what motivates most investors to hold on to losing positions in the hope that the price will eventually recover.
This is clouded judgment which contradicts the old saying "Cut your losses and let your profits run". Preserving capital makes sure you trade another day. Many novice investors do not realise the importance of cutting their losses early rather than letting them get larger and larger. Emotion dictates that if we do not actually sell the position we have not realised the loss! Is this really the case?
Many investors suffer from the wrong psychological mindset for trading/investing. Your psychological mindset will play the most important factor to your success in the market. Understanding the importance of trading psychology and practicing correct trading discipline will ensure you are placed in the top percentile of all investors. You are increasing your chances of success.
It has been argued that humans behave in quite irrational ways, for example:
1. Many investors and traders hold onto positions long after they should have disposed of them as they view paper losses differently from realised losses.
2. Many investors and traders attribute success to skill and losses to bad luck, quite often they rate themselves higher than other investors regardless of whether they are actually better at investing and trading.
3. Many investors and traders too often believe that they know more than they actually do.
Correct discipline will assist to combat the negative effects of psychology on any trader. The best approach to take with the market is that of a robot. It may sound ridiculous but a robot has no emotion and does not suffer from those "whispers" in the head which seem to plague many investors.
