How Negative Trading Psychology Lowers Returns
Guest post by Susan Porter. Many traders in today’s investment marketplace have negative psychological traits that can work against them. As prevalent as these traits can be, traders may not even be aware of how such negative traits can prevent them from making bigger returns.
Negative psychology is rooted in cognitive biases, or behavior patterns that distort judgment. Almost everyone experiences these biases, and in economic market situations, they can frequently be a hindrance. They may create a negativity that limits rational evaluation, or causes us to believe we have unlimited rationality. Because of this, economic and investment judgments are often less than rational. This leads to over confidence in investments or panic when one is doing poorly. It also leads directly to something that’s a key part of human behavior both in and out of the economic marketplace: loss aversion.
In fact, our aversion to loss is so strong that we believe we have control over our own behavior, when frequently we have no control either externally or as self-control. Our lack of self-control shows up in trading terms when traders reveal a tendency to overstate their resistance to temptation.
Selfishness, too, is a negative psychological trait, that can cause overestimating or underestimating of either value or risk of an investment.
Big returns on investments can be limited by loss aversion, selfishness and many other negative psychological traits that a trader – like any human being – can exhibit. There are cognitive biases in a number of areas that effect a trader’s actions and returns.
One common bias is the ambiguity effect, which causes one to avoid options that include missing information – thus a trader won’t invest when the probability of return is at least apparently not known. Another is the tendency to anchor, or rely heavily on a piece of information utilized in the past. Clinging to past marketplace evaluation is a sure fire negative for big returns, given the volatility of the marketplace.
A trader who exhibits a behavioral backfire effect will react to what should be new, altering information by instead strengthening their own existing beliefs.
Traders will also commonly fall prey to the bandwagon effect, which is the tendency to do follow a group dynamic about a given option. Similarly, traders would also be greatly affected negatively by basing judgments on specific criteria rather than more general and broadly inclusive information. This is called the base rate neglect.
Traders often also have the tendency to remember choices as better than they actually were which a choice supportive bias is. Interpreting information in a fashion that confirms their own analyses and preconceptions, a confirmation bias is another negative psychological tendency in the investment marketplace.
Sometimes, traders will exhibit conservatism or regressive bias, a negative psychological tendency to underestimate high values or overestimate lower ones. And considering the constant onslaught of economic information that fills a trader’s day, it’s not surprising that traders could experience the curse of knowledge, which occurs when the well informed are unable to understand others who are less informed than they are.
And certainly, exaggerated expectations and functional fixations create negative psychological experiences that affect a trader’s ability to perform successfully and consistently. The likelihood of thinking in terms of future probabilities as being controlled by past events, the so-called gambler’s fallacy is also a problem for traders. And certainly, so is the illusion of validity which makes a trader view consistent yet weak data analysis to create predictions that are more confident than they should be. And while it may not seem negative at first glance, being over optimistic and overestimating favorable outcomes or ignoring an obviously negative situation can certainly lead to less than stellar trading results.
Awareness of these negative psychological traits is the first step in besting them, and creating a more advantageous investment outcome for traders.
Susan Porter is a finance expert whose interests have led her to study all things related to market dynamics, decision making, and stock trading. Get more tips and advice on the blog Stock Trading!