Psychological challenges in trading

Why our emotions sabotage our returns

Seasoned traders through years of experience have become aware that their greatest impediment to success lies within their own minds. The emotions such as fear, greed and need for risk aversion are more potent reasons for loss creation than any market forces. For most traders dealing with trading in a technical and objective manner involves creating an investment strategy and a solid trading plan and working with it and periodically revisiting it to see where they erred and attempt to fix it for next time.

In the real world our objectivity is often skewed and gets clouded over with our emotions, biases and external trivialities. A perfect example of this is a trader with a solid trading plan who does not stick to it and keeps changing paths and adjusting strategies too frequently in hopes of a great windfall while failing to realize that not sticking to the plan over a proper time horizon is what is causing the losses and is the root cause of the problem.

Indeed emotions are a part of who we are and there is no magic elixir to solve the problem of lack of objectivity in our trading decisions but becoming aware of some possible emotional biases will allow us to avoid psychological pitfalls and become better investors.

Efficient Market Hypothesis: The traditional view on financial decisions

 The traditional theory of EMH which was developed by economist Fama proposes that investors are always rational and have little difficulty making financial decisions and are well-informed, careful and consistent. This theory holds that neither do investors get confused by how information is presented nor do they get swayed by their emotions.

That is indeed a tall order given we are all at the end of the day humans with our own emotions and quirks at play in all decisions.

The emerging field of behavioral finance

The fact that psychology and emotions play such a great role in what is otherwise considered to be a technical field has not escaped the eyes of academics or researchers. Behavioral Finance or “the application of psychology to financial behavior” has been a much analyzed topic in the recent past. Behavioral finance proposes that investors are rational but not completely so and respond to a great degree to natural psychological factors such as fear, hope, optimism and pessimism.

Nobel Prize winner Daniel Kahneman is one of the founding fathers of behavioral finance and the field has come to have an expansive meaning and encompasses anything that doesn’t conform to the Efficient Markets Hypothesis.

Growing popularity of behavioral finance

The field of behavioral finance has moved from purely academic interests to main stream finance. So much so that there has been an increase in number of firms that employ behavioral finance in selecting equities for their portfolio. Firms such as Fuller & Thaler and JP Morgan asset management have deployed behavioral finance considerations in selecting portfolios.

Behavioural finance theory in action: A case study (No news is news)

“The dog did nothing in the night time … that was the curious incident.” – Sir Arthur Conan Doyle

The statement from Sherlock Holmes inspired a paper titled “No News is News: Do Markets Under-react to nothing? Here the authors made an interesting observation which showcases how investors are not as rational as the traditional theories propose.  As per the authors’ observations the share prices of companies which are set to undergo a merger move or fluctuate much less with the passage of time than they would have if the investors had considered every aspect rationally.

The share prices of companies which announce mergers normally go up with the news spreading in the market. This is to be expected since mergers are made when the result of two companies coming together will increase the value of both companies. However in a Utopian market scenario as the time progresses beyond certain reasonable timelines without a merger actually happening these share prices should also come down since the probability of a deal falling through increases with elapsed time .But in the real world what is often observed is that the investors fail to account this ‘absence of news on the merger actually happening ’  because human behavior is such that we tend to focus on areas where action is happening and tend to lose sight of inactivity in other areas.

Thus investors fail to realize the importance of ‘no news’ or the news hidden and investors buy these shares even after a passage of time at higher rates than they should.

Part 2 and Part 3(Continued)

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