The Psychology of Trading and Investing

The psychology of investing is often ignored by retail investors. But behavioural finance and the role of psychology when trading is a growing area of research. Individual investors are at risk from a number biases, and knowledge of them could save them from making costly mistakes.

Here we explore different areas of social science that focus on investing, and specifically the psychology of investing. The biases, trends and influences that can lead to mistakes in terms of both performance, and also risk management. For those looking to delve even deeper into the subject, we also list the leading trading psychology books.

Psychology And Behavioural Finance

Way back in 2010, a veritable lifetime when it comes to tech advancements, the Financial Times ran an article on MarketPsy, a small California-based hedge fund that had started using behavioural finance trends to compile and analyse media and social media mentions and sentiment on companies and financial markets. Now in 2017, MarketPsy is still going strong and as well as asset management also sells its tools and analysis to third parties. The relative success of this hedge fund shows just how important a part psychology plays in trading and investing.

It hasn’t yet taken over the world, which suggests that their sentiment analysis still has its limitations and reflects just how complicated predicting the direction of financial markets and individual financial instruments is based on the wisdom of the crowd. Human psychology is complex but plays an important part in the way not only the markets move, but also on how people trade.

While developing a strong grasp of fundamental and technical trading and investing strategies is clearly a required prerequisite to success, the evidence shows that this is not the only factor, or even the most important. If it was, every professional trader or investor, and the financial institutions that combine the knowledge of hundreds of them, while harnessing the latest technology, would consistently beat the market. They do not. It’s a well-known fact that a very small percentile of professional fund managers consistently beat the market.

Is it Impossible to Beat the Market Consistently?

There are two schools of thought on this. The first is that, with a degree of variation, the top investors are relatively equally skilled. Their combined skill, and the decisions that result from that, drives the direction of the market as a collective. Due to wholly unpredictable variables such as technological developments disrupting a market, geo-political shocks or natural disasters, in any given year half of those skilled investors end up as winners and half as losers.

On this theory, the investor who beats the market 5 or 10 years in a row, while not downplaying their skill, has also simply been incredibly lucky that their decisions have dodged unpredictable factors that would have hurt the investment. They are simply the ‘few frogs’ who manage to make it to the other side of a busy road. The strategy or skill level hasn’t been particularly different to the hundreds or thousands who didn’t make it. They were luckier.

Now, there are some longer-term investors, such as Carl Icahn and Warren Buffet that have consistently beaten the market. A very good article on the topic written by Trent Hamm for the Simple Dollar blog argues that there is a simple reason for that and it’s not one that is applicable to normal investors. It’s also not directly based on behavioural finance or the psychology of when to buy and sell in the same way that applies to most investors. Hamm argues that investors such as Icahn and Buffet buy such large amounts of shares in the companies that they invest in that this is only the first step in their investment strategy. The degree of ownership they acquire allows them to subsequently manipulate the business of the company in a way that benefits them directly, potentially in certain cases to the detriment of smaller shareholders or even the long-term interests of the business.

“Superstar” Investors

There is a further element to this which does involve investor psychology. The track record of success that these ‘superstar’ investors have can, at least in the shorter term, significantly boost the share price of companies or other financial instruments they buy into. As even beginner investors will know, prices are an outcome of demand and supply dynamics. When other investors see an Icahn or Buffet buying into something there is typically an upsurge in demand as the crowd seeks to ride their coattails to profits. This becomes a self-fulfilling prophecy and boosts share price. The big initial investor can then sell off part of their holding, locking in strong profits which front weights the potential for the total trade to work out well, even if there is a subsequent dip.

It can be argued that at least part of the reason why superstar investors are so successful is by taking advantage of investor psychology. However, this is not an option available to other investors. Coming in right after a superstar investor, even if quickly, will mean losing out on at least some of the upside. Future downside must also still be pre-empted, with the investor choosing correctly when to exit the holding.

The good news is that when it comes to long term investing, not beating the market is not such a bad thing. Historically, global financial markets have, despite short term crashes and medium-term recoveries, continued to climb. So over a 10-20 year period matching the market performance is still profitable.

Profitable Traits

The second school of thought is that there are investors and traders who beat the market consistently and they do so through a strong grasp of trading psychology. Buffet and Icahn didn’t start out as superstar investors able to buy billion-dollar stakes in companies and then use that influence to manipulate the business in their direct favour. They had to build up to that point by being consistently successful. Did they get to that point purely by riding their luck? By being among the very few frogs that happened to make it to the other side of the road? Or were they just better than all of the other good investors?

Many extensive studies have tried to answer that question definitively and there is still no universally accepted answer. However, when it comes to shorter term investing, or trading, behavioural finance and psychology comes into its own.

Psychology Based Investment

Let’s return to our original example of MarketPsy, the hedge fund that bases its investment decisions on tech-generated behavioural finance data. After returning huge profits of 40% and 35% over its first two years, it lost money in the third, caught on the wrong side of biotech companies it had invested in being aggressively shorted. It blamed insider information in the industry and no longer invests in biotech.

MarketPsy and other companies in the behavioural psychology-based investment space have not yet delivered foolproof methodologies. However, the biggest names in investment have seen enough to start paying close attention to the theories behind market psychology and start to license their technology.

A professor of behavioural economics at Duke University, Dan Ariely, managed to auction a $20 bill for $61. The people in the room were all chartered financial analysts, expertly demonstrating the deficit of rationality behind money-making decisions. His accompanying warning was:

“If you think that people react rationally you shouldn’t be trading that much”.

However, Ariely himself admits that at this point in time behavioural psychology is “a collection of facts, not a complete theory.” Is the challenge then for traders and investors to find rationally predictable patterns within market irrationality?

Understanding Behavioural Finance Supports Irrational Trading

The sentence ‘understanding behavioural finance supports irrational trading’ may sound like a bad thing. However, when it comes to having the correct psychology to trade successfully, ironically it is quite the opposite. Where many traders come unstuck is by expecting markets to behave efficiently, or rationally, when in fact the opposite is closer to the truth. Markets are inefficient because the human participants behave irrationally, as demonstrated by Ariely’s $20 auction.

Understanding behavioural psychology helps traders and investors feel more comfortable in taking advantage of opportunities their rationality tells them should not be there. A financial instrument that appears undervalued, or a currency pair dropping for no apparent reason, is not necessarily a case of everyone else knowing something you don’t. Being consciously aware of this major influence on financial markets can go a long way to helping avoid panic-induced trades when markets unexpectedly move up or down.

The Dispositional Effect

The pattern of most investors and traders selling their winners and holding onto losers has been labelled the ‘dispositional effect’ by behavioural finance experts. The theory was first presented by Stanford University psychologists Kahneman and Tversky in the late 70s and explains our natural disposition to pick an option presented in terms of gains above one presented as a loss.

The classic experiment that illustrates this psychology is to present a group of people with the choice of a) winning £20 or b) winning £40 and then losing £20. Despite the fact that the end result is obviously exactly the same, option a) is statistically always by far the more popular choice. We naturally avoid the emotional blow of feeling like we’ve walked away with some kind of a loss, even if, objectively, we have an overall gain. We are also predisposed to cling to our losses because they are only crystalised at the point we exit a trade. Until then ‘things might turn around’.

The Dispositional Effect in Support and Resistance Levels

One of the first thing investors, particularly shorter-term traders, learn is about support and resistance levels in price direction of a financial instrument. A sustained march of a financial instrument’s value up or down is impeded by investors taking profits or holding on to losses. Prices take time to rise because increased demand from new buyers is balanced by selling as existing holders cash in profits as the price moves up. On the way down, prices rarely fall steeply because many holders don’t want to lock in losses. Traders who have shorted the instrument also sell the short position to lock in profits.

Rule No. 1 to Having a Successful Trading Psychology

One of the most fundamental rules in investing or trading is that ultimate success is not about how many winners or losers an investor has held. It’s about how profitable the winners are and how damaging the losers. The successful investor or trader ignores gains and losses made so far on a holding and constantly reevaluates the merit of retaining or selling based only within the context of that exact moment in time. Only in this way can the trap of the dispositional effect be circumvented.

Psychology Of Investing Books

We’ve hopefully provided a good general introduction to why psychology matters in investment and trading. Whether you believe that it’s possible for any one individual or organisation to consistently beat the market or not is largely irrelevant. Matching the market can be considered a success in itself and has historically been profitable. Doing so means being able to avoid the dispositional effect through good personal psychology.

It would not be possible to go into detail on different theories and elements of behavioural finance here in any value-added detail. For those interested in delving deeper, which should be anyone committed to becoming a profitable investor or trader, there are a number of great books on the topic.

Among the best, though by no means all, are:

Financial Behaviour: Players, Services, Products & Markets by H. Kent Baker, Greg Filbeck and Victor Ricciardi

Finance for Normal People: How Investors and Markets Behave by Meir Statman

Inside the Investor’s Brain: the Power of Mind over Money by Richard L. Petersen

Inefficient Markets by Andrei Schleifer