Psychology plays the biggest part.
A little while ago I wrote a blog on why retail traders lose and it gained some good traction (read part 1 here) so I thought I’d follow it up with some more points, predominantly based around the psychology of trading. So how does psychology affect trading? In a lot of ways trading is no different to gambling. If you bet on a football game you’re using historical data of the teams performance to predict a future result. The same applies to trading, we use historical data to predict future growth. The danger is when we actually treat it gambling. What do I mean by this? Quite simply most gamblers don’t know when to stop or cut their losses. They feel euphoria when they win, if they win more and more they believe they have an edge on the bookmakers. When they lose they chase losses and keep chasing losses until they blow their account and start again. The feeling of winning outweighs the losses so they keep coming back for more. They are addicted. This concept is exactly the same in the markets. People bet on companies that ‘can’t lose’ or a ‘sure thing’. They leverage to the hilt because they can’t lose, but unfortunately they can. Markets correct and crash. So what happens then? The trader chases a loss, they’ve lost 30% of their equity so they keep buying on the way down to catch the falling knife, but it keeps going lower and lower until they hit a margin call. But they are addicted to the thrill of winning trades and refund their accounts and do the same thing over again because they couldn’t actually be wrong. It’s obviously the institution’s pushing price lower but it will go up eventually….won’t it? How do we combat these emotions? 1) The first key to successful trading or investing is to detach yourself from the money in your account. The main way to do this is to ensure the money you are trading with is money you CAN afford to lose. If you need that money to pay bills or rent, when the market turns or you lose a trade you will be inclined to increase leverage on the next trade to make up the loss. This can quickly spiral out of control. 2) Don’t listen to others. It can be very easy to get swept up in the hype of a stock that ‘can only up’. You need to ignore the noise and follow facts. Read actual news on a company, not message boards or telegram groups. 3) Be realistic. This year we’ve seen a lot of traders make incredible gains. Remember this is not the norm. If you’re new to the markets you may assume that you can make 100% year on year. You can’t. All it takes is a small drop in some of hype stocks like $NIO and you’ll see people losing a lot of the equity due to being over exposed and over leveraged in one stock. The average return of the S&P 500 since inception is around 11%. If you can beat the benchmark year on year you're doing incredibly well. 4) Understand that you WILL lose. Everyone and I mean absolutely everyone loses trades, everyone will have bad months and bad years. That is a FACT. You need to accept that you won’t always be right and understand that it is ok to lose trades. You need to be ready to cut loses! 5) Be open minded. You may think a company is the best thing since sliced bread, but you need to be willing to change your bias. Changing your view doesn’t make your original decision wrong. It shows you’re willing to adapt to a change in the markets. If Elon left $TSLA tomorrow would it still be worth what it is today? 6) Never think you know more than the markets. You don’t. The markets can turn on a dime no matter how much research you have done or how confident you are in stocks going to the moon. 7) Treat it like a business. If you make a poor decision in business you will lose money and it is the same in the markets. Treat your investing like a business with a clear goal, rules and strict money management. Ultimately, most people will lose due to psychology and emotions overpowering logical reasoning. You need to combat the above psychological flaws before you can successfully trade over the long term. I know when I enter a trade where my exit point is so I don’t care if it drops 15% if I know my stop is 30% below the entry price. If it hits my stop so be it. My analysis was wrong and we move onto the next trade. Can you think of any further flaws people face while trading? Let me know in the comments below. Want to trade but don't know where to begin? Follow me on eToro for FREE.
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