Trading is not just numbers and screeners. Trading in the real market demands discipline and behavioural cognition just the way that life does. In this blog, we will discuss the human aspects of trading – emotions, fear, greed and how biases affect trading. We explain what is trading psychology, how to improve trading psychology and how to master trading psychology with this blog. We also explain how a trading strategy built on a solid trading plan, technical analysis, risk management with risk-reward ratios in mind can affect your trading decisions. We jot out in simple points how you should enter a trade, exit without losing money, stop loss from time to time, and how to handle losing a trade without negativity bias to enable you to evolve as a successful trader. We have also hand-curated book recommendations for learning more about Trading psychology.
The difference between an intelligent investor and a chronic gambler is just,
BEHAVIOR!
Bad Habits lead to Bad Behavior.
Bad Behavior leads to Bad Outcome.
Disciplined traders regulate their behavior and keep biases in check. You can do this by tracking your trading behavior or trading thought process quantitatively in a trading journal and making a note of the outcome of the trade every time. This can help you break bad patterns and loops.
Economic Theory Vs Behavioral Finance:
Economic Theory says Money is a Fungible Entity.
By Economic Theory:
If you have 25K Rupees in your hand, it is just Rs. 25K. Nothing more or nothing less.
By Behavioral Finance:
If you have 25K Rupees in your hand,
This can be,
- The Brand New Smartphone
- School Fees
- International Trip
- Medical Expenses or
- Savings.
The mind or rather, the heart assigns the same 25K, different priorities.
The same goes for how you earned that Rs.25K,
If it’s part of your monthly earnings or a premade budget,
The 25K Rupees can be a significant amount.
On the other hand, if this was a bonus,
There is a high probability that you will splurge this unplanned 25K Rupees on a Trip or shopping for nice things.
MENTAL ACCOUNTING:
The example demonstrated above is an example of mental accounting. This is why you are propelled to swipe with credit cards, or words like installment, rewards and BNPL kickstart a dopamine rush.
You are more likely to think that everyone swipes a credit card. Why not me? Are you taking into account your credit score and capability to pay back the credit every month after deducting for your expenses?
Sunk Cost Fallacy:
Let’s say you ordered Palak Paneer. The Paneer is soggy and the Palak smells bad. But, you still choose to eat it since you have paid for it.
Now, you have accrued two losses,
- The Palak Paneer you ordered was bad. (The decision to order Palak Paneer went bad but the outcome was out of your control)
- You ate the smelly Palak Paneer (The Decision and The Bad Outcome was in your control)
HOW DOES SUNK COST FALLACY MATTER IN LOSS AVERSION?
This trading psychology can be applied to Loss Aversion in the stock market.
You want to buy 1000 units of Clawberg Finance. Clawberg is a Finance Journalism outlet which sells the best-selling finance newspaper.
Clawberg is planning to change its fundamentals to become a company that distributes and sells curated newspapers and stop publishing its own newspaper.
So, the stock price has fallen. But you decide to buy this stock at the low price now since you feel that this is a popular stock and can increase in the future.
Deciding to buy just because there is a dip – Bad Decision.
Buying even though the fundamentals of the business have changed – Sunk Cost Fallacy!
Endowment Effect:
What I own has more value than what others own.
This is as much a marketing strategy as it is a Trading Psychology.
boAT followed this. So did Noise and Jio to attract users to the platform.
What is the Endowment Effect?
If you trade your used Honda M15 on CarDekho that is 4 years old in good condition for Rs.4 Lakhs.
But if you want to buy the same Honda M15 from CarDekho, you are willing to pay only Rs.2 Lakhs.
How did boAt manipulate this?
boAt sells earphones with moderate quality at dirt cheap prices. Let’s say Rs. 200 or Rs. 300 to college students. When they are salaried professionals, these students who trust the brand by now will most probably buy a higher-end earphone for Rs.2000 to Rs.3000/- from boAt itself since they trust the brand now.
So, the idea behind this is, the buyers have a good opinion on the quality of the Rs.200 wala Headphones. So, they believe that the Rs.2000/- one will also be of a decent quality. (No clarity on outcome. The 2K Rupees headphones could be trash. But boAt has already understood the endowment effect and acquired the users. Now the users are reluctant to change).
A similar sentiment is the reason why cults and influencers find it easy to retain followers once they are acquired sentimentally with an underlying emotional appeal.
Impact of Endowment Effect on the Stock Market:
The investor can wait to sell stocks since the stock price keeps increasing and feel remorse if the price drops.
Availability Heuristic:
If an information is easily available and recent enough to recall easily, then investors immediately act on it.
This is similar to trends on IG. Let’s us assume, that the movie RRR was a stock. When Naatu Naatu received an Oscar, the stock price would immediately hike up thanks to all the media attention this received.
The same happened when Zomato was releasing its IPO. Zomato announced that the key order metrics were improving and that it was able to penetrate the higher-end ordering market (Table for Two > 1000) more. Investors jumped to buy the IPO which crashed within a year and the valuation reset just last quarter.
Representative Heuristic:
Preconceived Biases – For Example, if prices of tomato in the market increased, everyone would invest in Heinz, the Ketchup brand that dominates supermarket shelves.
This was the reason that New-Age IPOs were heavily invested in despite overvaluation. Investors shot every reason and justification in the book to invest in these IPOs. The most popular one was, that the stock performed well in the USA.
Saliency Heuristic:
Investors react to an unusual event – wars and epidemics. Even if dissent or the impact of this event lasts just a day, these events impact a Bear Market adversely.
Anchoring and Adjustment:
This happens with investors who face difficulties adapting and adjusting to situations. Instead these investors anchor or moor a price in their head. The actual value can be too high or too less.
For Eg., An ask for ESOPs.
In the American Reality Television show Pawn Stars, haggling is always aggressive one sided. And mostly, the gullible who are not informed end up selling for too low a price or quoting too high a price that the product is not really valuable for.
Size Bias:
Just because both A and B invested the same amount does not guarantee the same or more or less same results.
A and B would have invested, diversified and reinvested in different asset classes and could have increased or reduced the value of the investment during different durations.
Hindsight Bias / Overconfidence:
Relying on overconfidence and past experience instead of quantitative inputs in decision making.
Solution: Trading Journal – Tabulate decisions, thought process and outcomes.
Self Attribution Bias:
Shifting accountability of poor performance entirely to intangible factors and assuming credit for the hay when the sun shines.
Irrational Exuberance:
Herd Mentality takes precedence over intrinsic value.
Trading Psychology Books:
If you are keen about books that talk about the behavioral impacts of trading, you should read
The Intelligent Investor by Benjamin Graham
From Stocks to Riches by Parag Parikh
Market Wizards by Jack Schwager
Trading in the Zone by Mark Douglas.
The first two books were curated exclusively for this blog. The last two books are the highest rated books that cover this domain.
My favorite concepts from the Intelligent Investor are,
Margin of Safety:
The margin of safety is the difference between the current market price – CMP of the stock and its intrinsic value.
Benjo recommends to track this margin to diversify the portfolio and track leverages to ensure that you have any measure for crafting a margin of safety. This margin is set aside to preserve capital and act as a bulwark against loss.
Difference between CMP & Intrinsic Value:
CMP is the price at which the stock is trading.
Intrinsic value of a stock = Intrinsic Value of a business / Number of Outstanding shares
Intrinsic Value – Sum (Free Cash Flow to Equity / (1+ Required Rate of Return)n + (Terminal Value / (1 + Required Rate of Return)
n is the number of years for which we are calculating the projection.
FCFE is calculated by the Sum(Net Profit after Tax + Depreciation + Increase in Working Capital + Capital Expenditure + Debt Repayment on existing debt + Fresh Debt Raised)
Projected FCFE for the next year after the FCFE is calculated by,
FCFE * (1 + Growth Rate)t
Where t is the number of years after the FCFE calculation.
Say, you calculate FCFE of 2017. t for the year 2022 is 5 years.
Terminal Value = The Value of the last calculated Projected FCFE * (1/Required Rate of Return)
Say, In this case,
Terminal Value = Projected FCFE of 2022 * (1/Required Rate of Return)
Benjamin’s method was to identify undervalued assets via the art of fundamental analysis and long-term investing strategy.
Conclusion:
Emotions and instinct are jugular and cannot be control. But quantitatively tracking and effectively managing behavior when investing makes all the difference between a successful investor and a casino gambler.
