Publicly listed trading and investments firm IG Group have researched the psychology of trading and decision making. According to the efficient market hypothesis (EMH), market prices reflect all available information and thus, are completely rational. Financial markets reflect all new information, meaning traders can logically use risk analysis to make informed decisions and turn a profit.
However, IG trading groups’ psychology research demonstrated that traders lose way more money than they make. Perhaps this is because, as humans, we are not rational 100% of the time.
So what did Ig Group find?
We’re all products of our environment, our decisions and our psychology. This means that in order to act rationally, and make the most advantageous decisions, it is vital to understand your mindset and the way it influences your time spent trading financial markets.IG Group
As the human mind is complex even beyond our current understanding, IG group focused on two factors that influence the decision making process in trading
Cognitive biases are, essentially, errors in thinking that can influence decision making. These errors may be based on memory recall or even attention. It is impossible to pay attention to everything, so selective attention may see you taking in certain information which can inform subsequent decisions.
Two biases that IG group magnify in potentially impacting trading decision is the availability bias and the loss-aversion bias. Availability bias is where your brain recalls information that is easily accessed. For example if you read an article about the financial market, containing false information, 1 hour before making a trade, the availability bias could influence you to make trading decisions based on that information as it was easily accessible.
Loss-aversion bias is when the desire to avoid loss is greater than the desire of a greater gain. For example, a trader may grasp to their losing trade longer than they should in an attempt to accept the loss and quit whilst they’re behind. Of course, this can lead to an even greater loss.
By being more self-aware of your own cognitive biases, where they come from and how you can minimise their influence on your trading decisions you are in a better position to trade in the market based on rationality.
Emotions influence our every day decisions and behaviour. How we feel about a person, a place or a situation will guide how we interact with it. The same principle applies to trading. Emotions run high and, when unmanaged, can lead you to make rogue trading decisions that result in loss.
Emotions like hope, similar to the loss-aversion bias, can lead you to hold on to losing trades for too long in the hopes that they will turn around and turn a profit. Anger or being triggered by a situation can lead to ‘revenge trades’ where traders try to teach the financial market a lesson and let them know who’s boss. Often, these are unskilled, uncalculated, impulsive trades that result in loss.
Similar to cognitive biases, being aware of your emotions at any given time can help you to become a better trader. Keeping a trading log and outlining when and why you feel strong emotions can help you to pinpoint the cause of your emotions and minimse the influence they have on your trades. Human emotion is not always rational, therefore they can lead to irrational decision-making. Don’t be that trader.
Know yourself, know your trades.
Check out the IG trading website which houses an interactive feature explaining the psychology of trading. Revise topics like: personality, social pressures and emotions and how they influence trading behaviour.
You can also watch market training webinars that teach you how to become a more successful trader by learning the psychology behind it.
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