The Psychology of Trading and Behavioral Finance: Introduction

While we may not like to admit it, we’re all a little biased. In trading it’s no different, and if we can learn to understand our biases, we can become better traders.

The psychology of trading and investment is both a theoretical and practical discipline that can be used as a tool to preserve your capital and to improve your overall performance. The psychology of trading applies research, methods, and models developed in the field of psychology to the challenges facing traders on a daily basis. It includes perceptual and emotional biases, stress control, and offers models of learning that can be used as a map or guide. The Comprehensive Model of Trading Competence highlights the composite areas of tactical and strategic actions required by traders to achieve competence. If a trader can understand and define the composite skills required, learning will be fluid. Traders also should strive to incorporate attainable goals, which can act as milestones in their personal development.

As a trader, I need to know how to improve my performance in an understandable and relevant format. As a simple working definition, behavioral finance examines how groups of individuals perform in an economic context, while the psychology of trading examines how the individual performs under conditions of uncertainty. Moreover, the psychology of trading provides methods and techniques that apply to specific challenges an individual trader may encounter. Much of economic and financial theory is based on the notion that individuals act rationally and consider all available information in the decision-making process. However, empirical research in cognitive psychology demonstrates that this is not the case. When faced with uncertainty, the evidence reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways we arrive at decisions and choices.

The recent academic discipline called “behavioral finance” examines theories of cognitive psychology and attempts to understand and explain how emotions and cognitive errors influence investors and the decision-making process. Many economists believe that the study of psychology and other social sciences can shed considerable light on the efficiency of financial markets as well as explain many stock market anomalies, market bubbles and crashes. Some researchers (not all) believe that these human flaws are consistent, predictable, and can be exploited for profit.

The Art of Speculation

Speculation comes from the Latin root “speculatus,” meaning to watch for or observe. This derivation implies that investors must be guided by an accurate picture of the facts and be aware of the cognitive and emotional pitfalls that relate to making investment decisions. The biases of decision-making are often referred to as cognitive illusions, and as with visual illusions, the mistakes of intuitive reasoning are not easily overcome.

The purpose of learning about cognitive illusion is to develop the skill of recognizing circumstances in which a bias is likely to occur and where critical and analytic thinking must support intuition. As investors, we are vulnerable to numerous cognitive biases that wrong foot us. We each have a personal inclination to succumb to certain biases of thinking and perception, which may or may not be shared to any great degree with our investor colleagues and friends. Let us examine a common perceptual bias and how it influences our beliefs regarding investment software and training courses.

The “Halo” Effect

If a person has one salient good quality, his other characteristics are likely to be judged by others as better than they really are. Handsome men and women tend to be rated highly on intelligence, athletic prowess, sense of humor and so on. In fact, physical appearance has little to do with such characteristics. There is a small correlation between being handsome and being intelligent, but it is not enough to account for the mistakes people make in their judgments. There is the opposite effect, which is known as the “devil effect.” The presence in an individual of one salient bad trait like selfishness can lower people’s opinion of all his other characteristics; he tends to be seen as a more dishonest and less intelligent than he really is.

Although psychologists have known about the halo effect for more than 75 years, it is remarkable how little notice is taken of it. Traders are prone to be influenced by the halo effect, and it is one of the strongest influences on a trader’s decisions in purchasing trading software or courses and developing a trading style. People marketing trading courses appear to have a good level of expertise, good physical looks, and extensive interpersonal and verbal skills. Furthermore, they are people with whom we are familiar, or to whom we feel close, and to whom we are attracted. Such people are able to exert more influence on us than others. The appearance of credibility to promote a trading course or software is important and used by marketing folks extensively.

Some famous investment gurus have used the halo effect to support their theories and views, whether the theories are accurate or not. For example, some traders who have no formal training in psychology have invented anecdotes to demonstrate the psychological dynamics of fear and greed at work in the individual and how this influences their trading. Some have even become experts in neurophysiology by making unsubstantiated claims about the functioning of the brain and its relevance to trading. In addition, I have seen traders run seminars using psychometric tests with little understanding of how to interpret the scores. But they can easily convince the audience that they know what they are doing and label their actions as methods of behavioral finance. The halo effect in these circumstances is potent and has been used equally effectively by stage “hypnotists.” Many of you will have completed “psychological” tests in trading books. Have you ever stopped to think - “On what data is this test based to ensure a reliable and valid score?” Traders would certainly ask this question of any trading system or methodology where they would invest time and money.

Be wary of traders who pretend to be gurus or Nobel Prize winning psychologists. (In fact there is only one Nobel winner in psychology of finance: Daniel Kahneman in 2002.) Be aware of how the halo effect biases your own perception. Many investment gurus have recognized that their credibility has been questioned as a result of not holding psychology qualifications and have allied themselves to the relatively recent discipline of “behavioral finance.” There are many valid reasons why the new discipline of behavioral finance is becoming popular. However, it is generally more acceptable for a trader to be an “expert” in behavioral finance than in psychology, especially if he has no formal qualifications whatsoever.

Don’t Be A Sheep!

Let us now explore the psychology of groups and how our decisions and beliefs may be influenced. Traders are generally aware that a person’s behavior tends to conform to that of any group of which he is a member. Belonging to a group, however, has other implications, and the interaction between members has significant effects on attitudes and their behavior towards other groups. As individuals, it would be reasonable for us to assume that our attitudes would drift towards the mid-position (regression to the mean) held by the rest of the group. However, research demonstrates that if there is a prevailing attitude in the group, it becomes accentuated in its members. For example, a group of traders who have an affiliation with, say, Elliott wave theory will see their techniques and methods as far superior to those employing other methodologies.

Experiments have been designed to analyze the decision processes of investment clubs and the results have been replicated and confirmed many times. The research assessed the degree of risk acceptable by an individual club member in purchasing risky stocks. After each had independently given the acceptable odds, they discussed the risks as a group in order to reach joint agreement about the acceptable odds. The group as a whole opted for significantly different odds than the individuals. In other words the group was prepared to take a greater risk than its members acting separately. This phenomenon has been termed the risky shift.

The demonstration that group attitudes are more extreme than those of individuals has been replicated many times and in different circumstances. The phenomenon occurs for a number of reasons. First, the group members want to be valued by the group. They may suppress arguments that are opposed to the attitude and beliefs of the group, and they may be prepared to be more extreme in the group because we know that membership of the group reduces individual responsibility.

The Optimists Club

Research also indicates that investment groups manifest an illusion of invulnerability coupled with extreme optimism. For example, they ignore inconvenient facts; they hold stereotyped views of rival groups. Individual members attempt to silence dissent from others in the group, and each member suppresses his own doubts in order to conform. In addition, there is an illusion of holding a unanimous view, and they protect other members by concealing information not in line with the group’s views. In fact, group leaders tend to pick those candidates whose ideas and attitudes most suit their own when a decision needs to be made regarding group membership. It is therefore likely that the group, through selecting these members, will become even more extreme in their views. I have been to numerous trading seminars where this phenomenon was evident and I am sure that many readers have observed something similar.

Stereotypes: A Dangerous Trap

It is difficult if not impossible to think of one’s own group and trading methodology as special without thinking that other groups or trading methodologies are inferior. Such prejudice against other groups is usually accompanied by the formation of stereotypes. Some reasons explaining the inflexibility and failure of some traders to adapt and learn new methodologies in response to changing market conditions are rooted in the same dynamic that forms stereotypes. One reason for stereotypes is that they are convenient; we do not have to assess the individual case. A second reason is we tend to notice anything that supports our own opinions but don’t pay much attention to those that might not support our view. Third, we are attentive to the actions of another group, which appear more noticeable than those of the larger group. They are conspicuous because they are rare. Forth, stereotypes can be self-fulfilling. Finally, when discussing the halo effect in relation to individuals, it is shown that the person who has one salient quality may be seen as having other related qualities that he does not in fact possess. For these reasons and others, prejudicial stereotypes are common and powerful and very hard to eradicate, and their basis in truth is unfounded.

It is comforting to belong to a cohesive group of traders showing a common philosophy, discipline and method of trading. It is difficult to think of your colleagues and tutor as special without at the same time making others appear “inferior.” These prejudices against other traders holding different beliefs about market trading are not based on facts. In other words, advocates of a particular method, or members of an investment club, are likely to pre-judge traders, their actions and their methods based on a false belief system.

Understand Your Biases

The risky shift and halo effect biases are discussed in detail in my book Financial Risk Taking and by other authors. The challenge for behavioral finance is to identify the mechanisms of biases and provide a model of learning for investors. The challenge for the psychology of trading is to make those models relevant to the individual investor and also to provide tools to overcome the damaging effects of biases on our trading accounts. The rest is up to us because we are our responsible for our success and failure. Recently I managed to increase one of my trading accounts by 256 percent. I increased my leverage and added positions with discipline, but I became distracted and made an error. Weeks of concentration, effort and profit were wiped out to near breakeven, and even though my emotional control is competent, I can’t help feeling discouraged. But I have a map, and I accept that I have no control over the markets; I only have control of myself.

Author: Dr. Mike Elvin

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