Thursday, 12 July 2007

Too much emotion!

"Price movement is a function of the collective perception of buyers and sellers in a market", according to Curtis Faith, in "Way of the Turtle". This definition says to me that the most important aspect of trading is an understanding of the psychology of buyers and sellers. He goes on to say, "Markets are comprised of individuals all with hopes, fears and foibles." and suggests that the trader's edge comes in "seeking opportunities that arise from these human emotions".

The subject of Behavioural Finance is a study of this. The subject is too big to cover in a post but I hope, in this one, to go over some of the factors that affect betting and laying decisions.

People tend to drive their decisions by emotions rather than rational reason. To back this up, an experiment was documented, whereby a man was found, who having had a stroke that damaged the areas of his brain that generated emotion, (so that all his decisions would be rational, reasoned and conscious), was found to be unable to make even a basic decision, constantly too-ing and fro-ing between alternatives. It turns out that emotions are the short cut that help us make quick decisions (and then justify, after the fact, with our rational mind (remember, hindsight has 20:20 vision!)).

Part of the reason people lose money when trading is due to these emotional short cuts, e.g.

  • People are prone to making systematic errors in circumstances of uncertainty
  • Under duress, people make poor assessment of risk and event probability

  • People rarely make completely rational decisions

Some examples of the emotions we encounter when making trading decisions:

  • Hope - "I hope it goes up after I buy"

  • Fear - "I can't take another loss, I'll sit this one out"

  • Greed - "I'm making loads, I'll double my position"

  • Despair - "The market keeps moving against me, whatever I do!"

Underneath these emotions are what are called cognitive biases. These are beliefs and attitudes that also lead us to make bad trading decisions. I'll talk about these in a future post.

1 comment:

OnePercent said...

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