How does psychology impact trading?
There are a number of factors that distinguish successful traders from the rest: experience on the markets, a tried and tested strategy, and an awareness of their own psyche. Developing the latter is not something that just happens overnight – it takes time and a willingness to analyse the decisions that you make.
The personality of a trader
According to a survey by IG Group, 55% of investors believe that they are disciplined and will stick to the rules they have outlined for themselves. Yet the company’s real-world trading data shows that traders lose more than they gain on average, despite correctly predicting market movements 55% of the time.
Figure one: percentage of trades closed at a gain and loss
There are a number of reasons behind this second statistic, but a lot of them can be explained by the mindset of the trader in question. Psychology impacts every decision that an individual makes. It is the basis of what motivates us and guides us, but it can also have a damaging effect on a trader’s portfolio if it is not checked.
When you’re trading financial markets, there are a whole host of other factors at play, besides rationality. For example, many traders might make decisions out of impatience, overconfidence or over-competitiveness.
The impact of emotions
Emotions can cloud rationality and make it difficult to acknowledge that the most rational decision isn’t always the most profitable one. Fear, for example, is drilled into us from an early age; don’t cross the road without looking, don’t talk to strangers, and definitely don’t spend all your money in one place.
While this is all good advice, uncontrolled fear is incredibly damaging when it comes to trading financial markets. Despite claims that traders tend to have ‘higher brain functions’, emotional responses – such as fear – can take over more complex thinking. The result is inevitably poorer trading performance, as it could cause traders to hold on to a losing trade or close a position too early to snatch profits.
Even positive emotions – such as hope – can have an adverse impact on a trader’s profit. For example, over-optimism can lead to traders holding on to a losing trade out of hope that the market will turn around.
The risk of behavioural biases
Most individuals will succumb to certain behavioural biases if they feel they are under pressure or exposed to more risk – which can be dangerous considering all trading involves risk. Perhaps the strongest predisposition for traders and investors is the loss aversion bias, which is the mindset that avoiding losses is more important than profiting.
This tends to manifest itself in a pattern known as the ‘disposition effect’, which is where investors and individual traders to hold on to ‘losing’ stocks for far longer than ‘winning’ stocks. This is usually out of fear of accepting a loss, despite the rational decision being to cut the loss and take a small hit.
The data collected by IG Group also found this trend. As we can see from the graph below, traders held the average loss in pounds for far longer than they held the average gain. The psychology of an investor can interrupt their decision-making rationality and lead them to hold on to losing trades, out of emotions such as hope and greed.
Figure two: average profit and loss in pounds
What can be done?
Some behaviours are so innate and instinctive, it can be hard to rewire the brain and change them. However, there are ways that individuals can ensure that the negative impacts of their emotions, traits and biases do not have a chance to materialise. For traders, this is having a solid plan in place that covers all outcomes – ensuring profit has time to run but losses are cut at the appropriate level.
This is where tools such as limit orders and guaranteed stops come in, which enable traders to set levels at which their trade will automatically be closed in profit or loss. These risk management tools mean that traders can step away from the markets, and let their trade run, without interference from their emotions or behavioural biases.
There is a consensus that education, risk management tools and experience are vital for traders and investors to avoid any potential psychological downfall, and have the best possible experience trading financial markets.
To find out more about the impact of psychology in trading and how to manage it, visit IG’s in-depth guide.
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