What Is Trading Psychology and Why Does It Matter? Saxo Bank

What Is Trading Psychology and Why Does It Matter?

Saxo Be Invested

Saxo Group

Summary:  The stock market can get the better of our emotions, which is why you want to improve your trading psychology. This article explores this branch of behavioural economics, including why it matters and the various plans you can put in place to better your emotions.


Many individuals may not realise that investing is an emotionally driven activity. For instance, when cryptocurrencies became a mainstream commodity, dozens of beginner, intermediate, and expert investors joined the trend out of a fear of missing out, a concept described in social psychology as the bandwagon effect.

For years, emotions such as fear, happiness, anger, and greed have presented themselves in the market. They can affect an investor’s decision-making process positively and negatively, dictating one's success or failure in investing in stocks and other financial instruments. Developing self-awareness skills is one of the best ways to counter any emotions or behaviours affecting your ability to make good investment decisions.

By reflecting, you can match the cause with the emotion to ensure you’re in the right state of mind when you log into a platform for investing. Industry experts refer to this idea of our emotions acting as catalysts for market investing in our trading psychology. We will explore this branch of behavioural economics in this article, including why it matters and the various plans you can put in place to better your emotions.

What Is Trading Psychology and Why Does It Matter?

Trading psychology relates to an investor’s emotional and mental state while making investments in the stock market. It also refers to an individual's emotional state as they enter and exit an investment platform. While every investor is different, the primary emotional catalysts associated with trading psychology include greed, fear, and regret. Also, positive emotions like confidence and pride can influence whether an investor secures a profit or sees heavy losses.

For example, feelings of greed can distract your judgement and rationality. This desire for wealth may trigger irrational investing, where you conduct high-risk investments or purchase shares without conducting proper fundamental and technical analysis. Fundamental analysis means looking at the overall economy to evaluate a stock’s value; technical analysis measures a stock’s future by looking at movements in its price and volume.

Likewise, fear is a compelling emotion that can cause you to exit markets too soon. Investors may also refrain from taking risks because of loss concerns. Fear can sometimes turn into panic, which causes the price of a security to drop without reasoned analysis.

Positive emotions like confidence can also have negative implications when it is not balanced and reaches extreme levels. For example, one concept in behavioural finance is self-attribution. Self-attribution refers to an investor’s tendency to decide based on overconfidence in themselves and their skills. Overconfidence in not just oneself but a particular market may lead to heavy losses if investors wait too long, thinking the market will make a comeback.

Investment Biases

It is not just your emotions that can influence investment activity, but innate biases that you may not realise you have. Biases can affect investments as they are often predetermined. They may also result in investors acting on a gut feeling rather than conducting rational analysis. There are many cognitive biases you should notice to overcome them quickly and efficiently. Some of them include: gambler’s fallacy, confirmation bias, representative bias, and status quo bias.

Gambler’s Fallacy

Gambler’s fallacy is a bias where an individual believes the likelihood of something happening becomes higher or lower as an event or process is repeated. Let’s say an investor continues to increase their position in a stock despite witnessing repeated and mounting losses. This investor believes that the stock price will most likely change direction as losses continue to increase, but this mentality is incorrect. Each event is independent, and there is no correlation between past and present occurrences.

Confirmation Bias

Confirmation bias is another common cognitive bias where you look for, believe, or favour information that supports/confirms your pre-formulated values or beliefs. Investors may also intentionally ignore information that contradicts these values and beliefs. For example, if you are steadfast in owning shares of a company, such as Tesla, Amazon, or Alphabet, and you may ignore unfavourable news about that particular company’s quarterly reports, you are committing a form of confirmation bias.

Representative Bias

If you are repeating investments for no other reason than because they previously brought you success, this is an example of representative bias. Another example is if you believe an investment is good or bad based on a company's past performances. Let’s say a business you have invested in releases a strong earnings report. You may assume that the next earnings report will be just as strong, but, as you now know through the gambler’s fallacy, past events don’t change the likelihood that certain events will occur in the future.

Status Quo Bias

Like representative bias, status quo bias means you are conducting old investments or using old strategies rather than exploring new options. If you are using old methods to execute new investments, you may be blinded by your perceptions and cannot recognise that the market has changed and your old strategies are not viable.

How Do You Recognise Your Emotional Mindset?

Recognising why trading psychology matters is as important as identifying the emotions, traits, and behaviours influencing your mindset when conducting investments. Below are five steps that will aid with this realisation:

Step One: Recognise Your Emotions, Biases, and Personality Traits

To recognise any negative emotions or personality traits that could affect your decision-making ability, the first thing you should do is to note how you feel when you log into an investment platform. Are you overwhelmed? Do you look for the best-performing stocks of the day and make assumptions about their future without proper analysis? Or, do you automatically check the price of a stock that previously gave you success?

Self-awareness and looking inward are crucial in trading psychology, and recognising from the start where these emotions and biases stem from will prevent you from making impulsive decisions or acting out of frustration. It's important to recognise your strengths and utilise them. For instance, if you are calm and confident without being overbearing, you can use these traits during your time in the market.

Step Two: Create an Investment Plan

Having an investment plan is also important in lowering the risk of your emotions causing you to behave irrationally in the market. You can work with your broker to create an investment plan or build it yourself. A good investment plan will include exit rules and mental preparations, like
a market mantra that you repeat before the day balances your emotions. As for exit rules, implementing stop-loss orders is one way to exit an investment if it goes against you. Stop-loss orders limit risk, and you can instruct your broker to close a position once it has reached a specific loss level. Investment plans should also include realistic profit targets, risk/reward ratios, and entry rules.

Step Three: Work on Developing Positive Traits

Getting rid of negative emotions and personality traits can help you. It allows you to develop new and more positive traits, such as patience and adaptiveness. Investment plans are one of the best ways to encourage patience because they help you separate the present from your long-term financial goals. However, patience also comes from understanding that market volatility is normal, not personal, and time is on your side. Similarly, learning to become more adaptive is crucial in maintaining your investment plan. For example, just because you have set out a plan does not mean you should never revise it or adapt it to new trends and market movements.

Step Four: Learn When to Walk Away

A fundamental skill in any investment is knowing when to take your losses and walk away. Just because you have lost does not mean you are a failure, or you should rush into making another investment to make up for some of your losses. Sometimes an investment won't work out, and it's important to recognise why this happened and adapt your trading strategy. Use a loss as an opportunity to learn about what went wrong and then use that knowledge to make better decisions in the future.

Likewise, investors should know when to walk away after a succession of wins. Luck always runs out, and you do not want to take unnecessary risks or gamble on your acquired profits because you are overconfident and happy. We talked about how anger can cause you to make irrational decisions, but happiness also has this effect.

Step Five: Write Everything Down

People keep diaries to express their emotions about particular life events. You can also keep a log to record how you felt during a particular investment. This will give you a good sign of what you did well or where your emotions and decision-making led you astray.

Top Books to Read about Trading Psychology

Reading is one of the best ways to improve as an investor. Below, you will find two well-known works that explore how psychology works in trading and investing.

Trading in the Zone by Mark Douglas

Trading in the Zone by Mark Douglas explores why investors take shortcuts in the market and why greed and fear have such an incredible hold over individuals. Douglas also provides solutions for how to prevent these issues from happening.

The Investor’s Quotient by Jake Bernstein

You can view Jake Bernstein’s book as an extension of this article. The author explores why investors fail because of their emotions and psychology. Bernstein also provides strategies and tactics for preventing and dealing with emotionally driven issues.

Key Takeaways

•     Investing is an emotionally driven activity, and these emotions can have negative affects on your decision-making process

•     A compromised decision-making process can determine your success or failure in investing in securities

•     The most common emotions associated with trading psychology include greed, fear, happiness, regret, pride, and confidence

•     Greed can cloud your judgement and cause you to make an irrational investment decision in pursuit of wealth

•     Some of the most common biases include confirmation bias, representative bias, status quo bias, and gambler’s fallacy

•     There are different ways to improve your trading psychology, such as recognising your emotions, creating an investment plan, developing healthier personality traits, and learning when to walk away

•     It is also a good idea to keep a log of your emotions when conducting investments so you do not make the same mistakes in the future

Quarterly Outlook

01 /

  • Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Quarterly Outlook

    Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Althea Spinozzi

    Head of Fixed Income Strategy

  • Equity Outlook: Will lower rates lift all boats in equities?

    Quarterly Outlook

    Equity Outlook: Will lower rates lift all boats in equities?

    Peter Garnry

    Chief Investment Strategist

    After a period of historically high equity index concentration driven by the 'Magnificent Seven' sto...
  • FX Outlook: USD in limbo amid political and policy jitters

    Quarterly Outlook

    FX Outlook: USD in limbo amid political and policy jitters

    Charu Chanana

    Chief Investment Strategist

    As we enter the final quarter of 2024, currency markets are set for heightened turbulence due to US ...
  • Macro Outlook: The US rate cut cycle has begun

    Quarterly Outlook

    Macro Outlook: The US rate cut cycle has begun

    Peter Garnry

    Chief Investment Strategist

    The Fed started the US rate cut cycle in Q3 and in this macro outlook we will explore how the rate c...
  • Commodity Outlook: Gold and silver continue to shine bright

    Quarterly Outlook

    Commodity Outlook: Gold and silver continue to shine bright

    Ole Hansen

    Head of Commodity Strategy

  • FX: Risk-on currencies to surge against havens

    Quarterly Outlook

    FX: Risk-on currencies to surge against havens

    Charu Chanana

    Chief Investment Strategist

    Explore the outlook for USD, AUD, NZD, and EM carry trades as risk-on currencies are set to outperfo...
  • Equities: Are we blowing bubbles again

    Quarterly Outlook

    Equities: Are we blowing bubbles again

    Peter Garnry

    Chief Investment Strategist

    Explore key trends and opportunities in European equities and electrification theme as market dynami...
  • Macro: Sandcastle economics

    Quarterly Outlook

    Macro: Sandcastle economics

    Peter Garnry

    Chief Investment Strategist

    Explore the "two-lane economy," European equities, energy commodities, and the impact of US fiscal p...
  • Bonds: What to do until inflation stabilises

    Quarterly Outlook

    Bonds: What to do until inflation stabilises

    Althea Spinozzi

    Head of Fixed Income Strategy

    Discover strategies for managing bonds as US and European yields remain rangebound due to uncertain ...
  • Commodities: Energy and grains in focus as metals pause

    Quarterly Outlook

    Commodities: Energy and grains in focus as metals pause

    Ole Hansen

    Head of Commodity Strategy

    Energy and grains to shine as metals pause. Discover key trends and market drivers for commodities i...

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)

Saxo
40 Bank Street, 26th floor
E14 5DA
London
United Kingdom

Contact Saxo

Select region

United Kingdom
United Kingdom

Trade Responsibly
All trading carries risk. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more
Additional Key Information Documents are available in our trading platform.

Saxo is a registered Trading Name of Saxo Capital Markets UK Ltd (‘Saxo’). Saxo is authorised and regulated by the Financial Conduct Authority, Firm Reference Number 551422. Registered address: 26th Floor, 40 Bank Street, Canary Wharf, London E14 5DA. Company number 7413871. Registered in England & Wales.

This website, including the information and materials contained in it, are not directed at, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in the United States, Belgium or any other jurisdiction where such distribution, publication, availability or use would be contrary to applicable law or regulation.

It is important that you understand that with investments, your capital is at risk. Past performance is not a guide to future performance. It is your responsibility to ensure that you make an informed decision about whether or not to invest with us. If you are still unsure if investing is right for you, please seek independent advice. Saxo assumes no liability for any loss sustained from trading in accordance with a recommendation.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc. Android is a trademark of Google Inc.

©   since 1992