One of the greatest challenges faced by investors and traders alike is learning how to manage emotions when investing or trading. It is within the nature of a human being is to show emotion and many investors, both professionals and amateur alike, often find their judgement clouded by a rush of emotions whilst trading/investing. In many regards, conquering emotions whilst investing or trading can be said to be similar to behaving as a machine, whereby you have a clear, structured path to follow and when something does not go in your favour, you remain indifferent and continue along your path. This is true master of emotions, but of course we aren’t machines!
Two abbreviations used to describe a distinct emotion that is commonly faced by investors are FOMO (Fear of Missing Out) and FUD (Fear, Uncertainty, Doubt). The former is typically felt whenever there’s an overly optimistic feeling about the markets and there’s an urge to rashly enter a trade/investment (to not miss out) without properly weighing the risks involved. On the flip side, FUD is typically felt whenever an investor/trader is in a losing trade and there’s a rush of emotions which causes the investor/trader to make bad decisions. These are both examples of FEAR and this is perhaps the most powerful emotion experienced whilst trading or investing that can cause bad decision-making.
Another common emotion felt is GREED. This emotion can be best described by the basketball allusion “the hot hand fallacy.” Whereby if a player makes a bunch of free throws consecutively there’s the feeling that he will keep on winning (i.e. he has a ‘hot hand); similarly when trading, riding a ‘big win’ can cause persons to feel as if “this is their big break” which can lead them to make rash, unwise decisions.
In this article I will give you 5 tips which can help you as investors or traders to manage your emotions to ensure better decision-making. Note, this is not a guarantee, but I can say with confidence that with discipline and experience, you will learn to have a better grasp on your emotions. Now let’s get into these tips:
1) Always stick to a game plan
Remember the best traders and investors all have a strategy that they follow and stick to. This helps with risk management and also to keep emotions in check. You most definitely don’t want to be in a scenario where you’ve opened a trade or invested in an asset and it doesn’t go your way without a set plan/strategy because I can guarantee you’d be scrambling to make a reflex decision which may not be the best.
Having a set plan can include, a fixed risk to reward ratio for each investment or trade; meaning a target profit and stop-loss is set and enforced. There are many instances where traders and investors execute without a plan and they begin ‘dollar cost averaging’ into their positions until the size of their positions becomes too large to manage. A comprehensive strategy always ensures you know exactly how much to invest and when to execute it.
Hand in hand with the risk to reward ratio, is portion sizing which is another important risk management aspect within a game plan. If you find yourself with bigger than ‘stomachable’ losses, you need to adjust your position size to something you’re more comfortable with. Personally, I also always ensure the size of my long-positions always exceeds the size of my short-positions and these are fixed! This is because I know that only a fraction of traders/investors are willing or able to short sell, whereas most investors and traders trade bullish.
2) Don’t hold on to your previous trades
First you need to know, it’s ok to lose. Losses are all part of the investing and trading process and ALL traders and investors have to face them one day. The most important thing however, is minimizing these losses through good risk management techniques.
Holding on to losers forces you to try to compensate in your next investment or trade (i.e. a revenge trade). This is perhaps one of the most common practices of newbie investors and traders as losing money is never a nice feeling. Daniel Kahneman and Amos Tversky’s “loss aversion” principle best describes the reasoning for this behaviour. The principle asserts that the feeling felt when losing in an investment or trade weighs heavier on the emotions of investors and traders than that feeling of winning.
Similarly, investors and traders are obliged to go with what works for them and choose to not abandon their winning trades due to previous success. This is most common for longer time frames, whereby, investors or traders develop a ‘soft spot’ for particular companies or positions that they think won’t fail them.
In this regard, it is always best to treat each trade/investment as a blank sheet or a clean slate because not doing so can cause a high level of greed when winning (as described above) or frustration when losing.
3) Educate yourself, but don’t be influenced
With a little experience comes the feeling of “being a financial expert” of some sorts to some investors and this can lead to the formation of narratives or opinions. Now, having an opinion is not a bad thing, but it can get you to stray from having an objective mindset to a biased mindset causing bad decision-making when trading or making an investment.
Markets aren’t fully rational, and it is important to realize that there are so many variables that drive the prices up and down. Many economists are sometimes labelled as ‘perma-bulls’ or ‘perma-bears’ since they hold a particular directional bias on the markets. However, there exists times where the markets act in a manner contrary to economic conditions and we as traders and investors should not allow our opinions to stop us from making money in either direction!
Another way investors and traders can be influenced, is through excessive engagement in chatrooms and online forums (e.g. social media, CNBC, Yahoo Finance, etc). Typically, the groupthink behaviour is propagated when individuals seek ideas and trade off the successes of other investors. This leads to irrational decision-making and instigates investing and trading without a proper basis or understanding.
4) Put things in perspective by asking the right questions
‘The problem isn’t the problem; it is the way you look at the problem’ is quite a common phrase that I believe has applicability in this context. Many times, traders and investors get caught up worrying why the markets go up and down but forget to ask themselves the more important question of “what are you doing as a result of this?”
Questioning your decisions and your process offers a far bigger advantage and lesson to be learnt than questioning things that you don’t fully understand. A familiar notion in Finance that, “markets have a mind of their own,” allows us to understand that NO ONE can predict the markets fully. Financial investing and trading operates as buy-sell transactions and as one party in the trade, you should always ‘put yourself the the opposite party’s shoes’ and consider the reason, why would someone want to sell or buy something that you want to buy or sell?
5) Take a Break, then start again SMALL
Finally, but perhaps most importantly, is taking a break. If, as an investor or trader, you feel as though you’ve aren’t thinking rationally or aren’t able to follow the 4 points above then you should take some time off investing or trading. Doing this clears your mind and offers you the opportunity to distance yourself from the emotional connection. Activities such as meditation, playing a sport, playing a musical or reading a book can allow you to take your mind off trading and investing in the short-term.
Once you have done this, you should start again incrementally. Small steps allows for you to rebuild your confidence and get you into a frame of mind to make money, after all the last thing you want is to take a break from losing and then restart with a massive loss, it’ll be crushing.
It is always important to remember that there will always be an opportunity to make money. Many investors and traders get caught up in the moment, thinking ‘this is the big one’ or ‘it’s different this time’ and forget to understand market cyclicality. There will be opportunities missed but also many more to come, and it is through managing your emotions properly that you will be able to take full advantage of this! Even the best investors and traders in the world recognize this: Below is a quote from Berkshire Hathaway Vice President, Charlie Munger when he and Warren Buffet discussed missing investing opportunities in Amazon and Google.
We will keep missing them!
Our secret is that we don’t miss them allCharlie Munger
As investors and traders your main goal should be to make money by practising proper risk management techniques not via ‘gambling’. Managing your emotions is essential to risk management and should never be taken lightly. Following these pointers above can give you an idea of some ways (and there may be more) to help with this process but true emotional management is up to you.
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