Every investor’s decision for buying or selling a financial asset should take into consideration several factors to pass from the theoretical to the practical point of view. The decision itself consists of several steps, but one of the most important factors is the trader’s trading psychology.
With the term trading psychology, we refer to the emotions, mindset, and the general mental state a trader has. This metal state includes various emotional factors like greed, fear and self-control and discipline.
Some examples of trading psychology may include:
The optimism of normal profits turns into a dream for excessive gains and controls a trader’s mind. Taking higher and higher trading risks with the hope of significant rewards is not always the prudent path to success. Every trader imagines more gains and more profits, but it is wise to realize and face reality in terms of returns on investment(s). Greed will lead a trader to open more positions, hoping for more profits but at the end no one ever managed to become profitable following this practice. Greed appears mostly during bull market periods where traders stay at profitable trades more and longer than they should.
Anxiety prevails at the mind of a trader, while the thought of losing the invested capital may lead to panic especially when the market conditions are not favorable. A trader can check the investment and see losses, may not be able to handle himself/herself and take some impulsive decisions. On the other hand, a trader can check some small profits and close the orders fearing that the market will reverse
A well organized and disciplined trader has a solid trading strategy and follows a specific plan. Discipline and focus on a predefined goal are important especially when the market prices and volatility are not in a trader’s favor. There should not be any room for uncertainty.
While a trader should feel confident about himself/herself, excessive confidence may be disastrous. A trader who is too confident may underestimate the risks involved, overestimate his/her knowledge and trading abilities and hoping for ‘guaranteed’ profits may end up losing significant invested amounts.
A focused trader who has self-control over his/her emotions can stay calm and follow a predefined trading strategy. Especially if things are not going in his/her favor and the trading market seems to be unstable and turbulent, self-control plays a significant part to remain calm and to regain our confidence.
One of the most characteristic psychological errors many traders make is the loss aversion. Traders focus more and more on the losses and the losing trades. They finally end up focusing on their losses and how they will compensate them or get back to even their investment and forget about the initial trading strategy which goal was to make profits. The loss aversion ends up consuming psychologically the trader, making him/her nervous and taking one wrong decision after the other. To prevent loss aversion, traders should reconsider their trading plan and check the market conditions, which in the meantime may have changed dramatically.
All the above are part of the behavioral finance science, a scientific field which deals and examines in depth how psychological biases and behavior (rational or irrational) affect financial decision making. Psychology, economics, and finance all come together to explain the key factors and how people take investment decisions.
Taking into consideration input from all three fields, we can reach to a more solid and realistic understanding on how financial markets work, and how a well informed and unbiased trader or investor can make right decisions identifying real market opportunities. Financial professionals and investors can highly benefit from the insights provided by behavioral finance and apply them to their investment strategies and decision-making processes having better short term or long-term results on their investments.