Stock Trading

Stock Trading Basics – The Mindset

Trading stocks is hard. You need to guess the right stock, the right price, and the right direction in order to make money. Options are even harder, because the contracts come with an expiration date before which your prediction must come true. That’s four obstacles you need to overcome in order to get ahead. In truth though, there is a hidden fifth – your own mind.

One could write an entire book on the subject (and people have) but today I will examine some common mental flaws and shortcuts that impact everyone, traders and investors alike.** Many of these are inherent in our everyday thinking, but if we become aware of them, that gives us a valuable opportunity to fight back, to trade and make a killing in the market. I can personally attest to having fallen victim to every one of these at some point in my life.

Misperception from Bad Framing

Framing is a term that refers to the way that we take a large, complicated structure and simplify it by putting a “frame” around key parts that we care about and ignoring the rest.  For instance, when you see a photo in a magazine, you rarely see the entire photo, but only a small cropped section that can best sell a product.  You see the model and handbag, but not the handful of people organizing the lights and background and props around them. In a similar fashion, people take the stock market and interpret it according to their predilections. Some people like to buy a stock and watch it grow, others to bet that a stock will crash and watch it sing.  Others suffered through a recession or prospered during a boom period, and so they view all market action as being a part of a recession or of a boom respectively.  The reality may defy both – the market could go sideways! This can also occur if people are simply using a bad framework to interpret the market and don’t understand what to look for. They look at a graph online and they might as well be staring at a car engine or nuclear reactor for all that they understand of it.

For a broader analysis of this, I strongly recommend Analogies at War by Yuen Foong Khong, which examines the stories policymakers were telling themselves about the nature of the Vietnam War and how it guided their battlefield strategy. It’s a fascinating book.

Cognitive Dissonance

Another flaw related to framing is something called “cognitive dissonance”, where people struggle to acknowledge that reality is different from the picture in their head.  For example, when you put on a trade, you have an idea or narrative of how it will go. “I’ll buy this stock low, the stock will go high in a week or two, at which point it becomes over valued and I sell.” You become emotionally attached to this idea and initially ignore contrary information as irrelevant or unimportant. “The stock seems to be struggling to pick itself off the floor…that’s alright, it’ll work itself out soon” or “The volume is really low on this move. Do people not trust the stock…? No, I must have seen something no one else did!” Eventually the weight of reality becomes clear and people discover that this information was actually the precursor to bigger things. It is difficult to keep an open mind when challenging information is coming in…and accepting that it is more accurate than your own understanding.

Backwards Dealing

The opposite of cognitive dissonance would be backwards dealing. While cognitive dissonance occurs when you are too tied to an old idea, backwards dealing occurs when you are too caught up in recent events. To put it another way, if you sufer a string of wins or losses, you believe that the recent events guide reality more than the larger picture does. You become too aggressive and take too many risks – this boom will last forever! – or too cautious and miss out on big gains – the economy will never come back! Traders suffering from this also tend to think that X stock will react to news the same way that it did in the recent past. “The stock had good earnings last quarter and soared, I bet it wll do the same this time too!”  They fail to understand that time and context are ever-changing, and expectations change with them. If people could predict that stocks would move exactly like they did in the past, everyone would be rich.

Anchoring

Another mental heuristic similar to framing is “anchoring”, where your mental picture gets hung up on one or two key facts.  The two most prevalent examples in stock trading are (1) the entry price of your stock, and (2) the stock’s high/low prices.  People can get caught up on these numbers and feel that they can never sell unless they break even on a stock, or that they can never sell unless the price reaches its previous high, or refuse to buy unless its exactly at the historical low. They also put too much faith that a stock’s high and low price simply will hold when challenged by the trend. You simply can’t assume that a stock will return to your entry price, or that the previous high will be reached, or that the price floor won’t be broken forever.  While stocks tend to follow trends and hover around key price points, there is no iron band locking the stock down.  For example, think of all the stock traders who bought at the high before the crash that kicked off the Great Depression. Those who refused to sell until their entry point was hit again likely had to wait nearly 20 years before the market came back to its earlier valuation post WW2, and that’s assuming the company survived in the first place. Know what you’re anchoring information is and know when it no longer holds true.

Overconfidence

They say that the worst thing that can ever happen to a trader is to make a lot of money on their first trade. Success quickly goes to people’s heads and they assume it will continue forever. They think they’re geniuses and that the odds don’t apply to them. Consequently, they take risks that are not supported by the technicals and assume positions that are too large for their portfolio. This is a difficult challenge to overcome because when you’re overconfident you are happy, and who doesn’t want to be happy? Unfortunately, our normal emotional reactions are actually badly suited for stock trading. Ironically, being happy is generally a sign its time for you to sell and exit a position.

Excitement & Repetition

Closely tied to this is an addiction for excitement and repetition. When you win, you feel a rush and want to experience it again and again. You assume that the pattern that made you money will repeat itself, and latch onto the next trade too quickly. This thirst for adventure drives people to bend their trading rules and take low-odds bets.  But the truth remains: stock trading is about making money, not excitement.  As a common metaphor puts it: “Trading should be as boring as washing your hair.”  When you can trade in that state of zen, and feel no pressure to get in or out, that is when you’re in the right emotional space.

Ego Protection

The reverse of overconfidence is ego protection. When you make a mistake, you don’t want to admit that you’re wrong. You hold onto a position long after you should have exited and you start creating new reasons for holding, reasons like emotional ties or faith in a stock over what the market is actually doing.  When suffering from this, people often make the market a personal matter and any challenge becomes an affront to their very being.  It’s necessary for traders to quickly learn that the market is massive – even billionaires like George Soros are small fishes in that ocean.  What does that make you? Do not feel ashamed about making mistakes. No one is watching, and if you make a mistake you should exit and learn to avoid making it again.

Closure Avoidance

Related to ego protection is closure avoidance. Exiting a position means an end to an idea, to excitement, to a dream. It also means an end to hope; the death of hubris and the acceptance of humility.  We can give up many things easily, but an idea or dream are much harder propositions. For example, there are many people in the world who never do anything decisive out of a desire to keep their options open. But you can never pursue all options and picking all of them you chose none of them. Traders who refuse to sell implicitly accept that they will never make money in the market. They tell themselves, that they’re not really wrong and that they haven’t lost money because they didn’t sell the stock. It could always come back! But in truth, they’ve still lost time (which you can never get back) and the opportunity to invest in other things. Do not get tied to any particular idea about how the market ought to work.

Perfectionism

Perfectionism is another flaw that plagues everyone, particularly traders. Traders don’t just want to make money, they want to make the most money. They try to time the market and aim for the perfect entry and exit, where they can brag that they scraped the last penny from a trade. As a result, if they try to buy low they may buy a stock right before it collapses, since they got in before it started correcting itself. If they try to sell high, they wait and wait only to discover that the moment has passed and that they’ve given back most of their money.  In another respect, perfectionism makes traders too cautious. They won’t get into the market unless the technical setup is just right. They also hang on to a losing stock too long because they want to secure a profit no matter and keep a perfect record. Either way, perfectionism is poorly suited to stock trading. Like all things based on human behavior, it does not obey the law of physics. It operates by a set of odds and your goal should be to get on the right side of them.

High Stress Decision Making

Stress is also an unavoidable obstacle to traders. Since, the brain is a biological construct that operates in a bath of chemicals, every wobble in a stock price creates stress hormones that puts new ingredients in the stew.  Do I sell? Do I get in? Do I need to a make a choice here or do I hang tight? Every second you wait feels like an eternity and you have an overwhelming desire to do anything to exit the situation. Regardless of your trading rules and experience, if you don’t find a way to manage stress you will make hasty, poorly thought-out moves that cost you money.

In conclusion, we’ve covered a number of the mental flaws and shortcuts that traders may experience. Our minds may deceive us by drawing up a false mental image, hanging on to the wrong facts, getting swept up in excitement or despair, or being impaired by stress. Of course, while it’s useful to know about all of these problems, what are the potential solutions? I’ll touch upon those in my next post.

**These are known as mental heuristics, which Wikipedia defines as “simple, efficient rules which people often use to form judgments and make decisions. They are mental shortcuts that usually involve focusing on one aspect of a complex problem and ignoring others.”  You can learn more about them by researching a subject called decision making theory.

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