It was the autumn of the year 2008. I was on flight from Vienna to New Delhi at a time when Europe had just about started witnessing the tremors of what would later come to be known as the Great depression II. I picked up the Financial Times and read what the then French President Nicolas Sarkozy had to say about the efficient market hypothesis – “the idea that markets are always right was a mad idea”. He was not alone in discrediting the stock markets, or capitalism as whole for that matter. Everyone was clueless. Over the next few months, stock markets in India declined by over 60%. Most investors lost a lot of money.
‘Some’ traders became overnight millionaires. I say ‘Some’ because here too, a lot of traders lost money. Recently, a friend of mine who trades rather heavily told me this:
There is evidence that at least 15 times in a year, the stock markets move up or down by over 2% in a single session. These are the days on which I make maximum trades
Clearly, if you were following his approach around 2008, you could not have been amongst the ‘Some’ who made money. What is it that sets some traders apart? How do they manage to beat the broader markets and forecast better than the heads of central banks?
Psychology of a Stock Trader
I have always believed that the business of stock investing thrives on 3 things –Intelligence, Psychology and Information.
If all humans had the same level of IQ and everyone was emotionally zero (i.e. had similar psychological traits) and if the flow of information to everyone was equal, then what purpose would the stock markets serve?
None whatsoever.
In fact, it would become the most boring fixed income scheme you could invest in.
Nevertheless, of these three traits, human psychology has the maximum impact on the movement of stock prices in the short-medium term. It is the psychology of a trader to overcome biases and human emotions like greed and fear and envy and desire that sets him apart from the others. Mostly, a trader just reacts and makes a lot of money if he can correctly predict the behavior of others.
There are many emotions and biases that play on our minds and there is certainly no shortage of reading material in this area. I will try to list down the ones I believe are most relevant for stock traders and how one can rise above them:
- Reliance on Hope – We all go through this. It’s like gambling in a casino. You keep betting either to win more or to recover what you have lost. While the philosopher in me realizes the power and importance of hope, as a stock trader just make sure to throw ‘hope’ out of the window before you get to the terminal.
Never ever let your hopes decide your trades for you. Markets will never perform the way you hope they do. An experienced trader always works with a strict stop loss in mind and never lets a single trade result in a big loss. Remind yourself of the golden rule once again –you don’t have to be right 10 out of 10 times. If you are correct 6 times, you will be extremely wealthy. Just make sure that you are happy to take losses on the 4 occasions where the market beats you.
If you want to take it to an extreme then I will tell you what helps a friend of mine, apparently. He has a placard hanging right above his computer screen which says – There is no hope!
- Envy – ‘The everyone is doing it syndrome’:
Quoting Buffett:
Its not greed that drives the world, but envy
At the peak of the Smartphone Buying spree last year, it was not uncommon to see people carrying 2 phones (in some cases, each phone supporting dual sim cards :-). This was no ordinary craze; people went out of their way to get credit cards which supported Smartphone EMI’s. I myself fell victim to the frenzy. I bought a Samsung, followed by an apple and am still convinced that nothing beats the blackberry (I think I am too old for touch screens).
Rise above it – For the love of god, just stop it. I have 2 spare, relatively new phones now (and a few thousand less in my bank account). I know, I should have followed this before preaching.
- Anchoring – A situation where one starts relying a great deal on the very first piece of information to make future decisions. For example, I may be convinced that as more and more people in India, especially in rural India, start adopting toothpaste over traditional forms of dental care, companies like Colgate Palmolive (which has over a 50% market share in Indian toothpaste market) will do extremely well. The ‘growing toothpaste market’ will then become my anchor and my judgment in future will reflect this heavy bias (i.e. my emotional inclination towards liking Colgate will bias my decisions).
Rise above it – Evaluate everything on an individual basis. No one is infallible. Remember that MTNL (the Indian government owned monopoly in telecommunications) was considered one of the highest investment grade stocks until a few years back with its wide network and customer reach. Along came Airtels, Reliances, Vodafones etc., and MTNL seems to have no economic advantages anymore (In the last 12 years MTNL has lost 96% of its market cap!!).
- Confirmation Bias – Closely related to the anchoring tendency is the Confirmation bias where one starts favoring information that confirms their preexisting beliefs. To explain in context of the above example, once you buy Colgate share hoping that the growing toothpaste market will result higher share price, you are likely to hunt for any information or news that supports your decision.
- Overconfidence – ‘The dare-DEVIL attitude’ – Overconfidence prejudices the psychology of a trader more than any other emotion. Beware: it poses a particular threat to the trader who has been successful at making money trading stocks.
Rise above it – Let me tell you a story I read in Nassim Taleb’s classic book, ‘Fooled by Randomness’.
A group of people participated in a contest of flipping coins and predicting the side on which the coin would land. Each contestant would play against the other in rounds of elimination until they reached a winner. After a few rounds when only some contestants remained (who of course had correctly predicted the landing of the coin on all previous occasions), they were asked how they managed to be correct each time. Many of them answered that they had mastered the technique of flipping coins. Of course, the probability of the coin landing on either side remained an exact 50%, in each case. Remember, each trade is new and has nothing to do with previous circumstances, even if the script and the trader remain same.
There are many other emotions that play on our minds. Recent memories of success or failures begging you to try it again or avoiding what you did earlier? Wanting to short the stock after it fell by a few percentage points may be just a few moments after someone confirmed that he is shorting it? The fear of loosing it all? The desire to make more money?
Trading is the art of overcoming such emotions more than anything else. When faced with such difficulties, take a deep breath, clear your head . . . . may be take a short break from trading before you get back in. Good Luck for Good Trades!
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