Why is behavioral psychology so important in trading?
In terms of finance, behavioral psychology helps us understand our behavioral flaws, which can lead to higher self-awareness as traders and increased investing success. This session will cover many behavioral theories and patterns that may have a negative impact on our portfolio, as well as some coping measures.
The Dunning Kruger Effect
You’ve surely noticed that everyone has suddenly become a “expert” on things like sports, politics, trade, or how “you should purchase Bitcoin because it will touch $1 million very soon.” Some of the persons disseminating this knowledge appear so assured that you nearly believe them. But as you pay closer attention, you’ll notice that they don’t understand half of what they’re saying.
This unusual phenomenon is known as “The Dunning Kruger effect,” and it might have an impact on your trading decisions. It explains why people are unable to perceive their own limitations. People cannot objectively appraise their own ability or incapacity without self-awareness. This is why many traders are dissatisfied when they do not make the expected gains because they are unable to identify their own ignorance.
The Fear of Missing Out
Fear of missing out, or FOMO, is another unusual and perhaps deadly behavioral habit. It has no technical or fundamental basis, as it stems purely from the fact that we are still human traders. We aren’t machines that follow a set of rules. FOMO is an emotional and reactive response. But it’s normal and, in most cases, unavoidable unless you’re self-aware enough to recognize when you’re being duped. You probably know what we’re talking about if you hear traders moaning about missing too many opportunities to buy a fast-rising stock.
Here’s a graph to help you understand this risky practice.
Let’s talk about stock market bubbles and Herding behavior
The first step in avoiding investment mistakes caused by behavioral biases is to be aware of them and to comprehend how they operate. Stock market bubbles are an illustration of this, as most investors continue to buy while knowing that stocks are highly overvalued. This communally irrational conduct can affect any traded good, not just stocks.
For example, the term “tulip mania,” which can refer to any major economic bubble, has its origins in the 17th century Netherlands, where tulip bulbs grew increasingly fashionable, and prices rose until massive sums were paid for a single tulip bulb.
The effects of group dynamics on investment returns can be significant. Not only may Herding Behavior lead to investors purchasing high and selling cheap after a bubble bursts, but it can also lead to investors buying assets that are unsuitable for them. Many private investors, for example, who lost money when the technology bubble burst in 2001 lacked the high-risk tolerance required to invest a large amount of their portfolio in such stocks. Furthermore, most did not balance the risk they took in the technology industry with the rest of their portfolios.
How to handle Group Dynamics
Only follow an investment trend if it is compatible with your current personal portfolio, risk tolerance, and investment strategy. Benefit from the advantages of collective decision-making, such as increased accuracy and a wider range of options. However, be wary of the dangers of group influences, such as in-group pressures that might stifle competing ideas and the illusion of collective invulnerability.
Our opinion of a stock has an impact on how we react to fresh facts about it. We have a tendency to focus on information that supports our current viewpoint and to dismiss information that contradicts it. Even if an investment that resulted in a loss is currently very appealing, we have a tendency to keep a negative attitude on it.
What is the best way to deal with selective perception bias?
Use a trading method that is based on numbers derived from technical or fundamental analysis, and act on these indications with discipline. Set and stick to stringent stop-loss targets.
Pride and regret are human qualities that explain why we don’t always make the greatest judgments. Another instance in which we injure ourselves is when faced with speculative, hazardous decisions: we’ve discovered that when private investors lose money, they’re more likely to take on too much risk.
When faced with losses, many investors respond by taking on significantly more risk, which can have disastrous consequences. While most investors attempt to avoid losing money, some very speculative ventures are prevalent. The resulting portfolios are weighed in separate mental accounts, each with a distinct risk tolerance. So you want to keep the magnitude of these speculative investments to a minimum. Always invest based on a solid investment case rather than throwing good money after bad.
One of the most effective methods to stop losing money in trading and start making consistent gains is to become self-aware and admit your own faults. If anything you’re doing isn’t working, admit that you don’t know everything and that you need help. To put it another way, you must constantly be willing to learn.