What Top Traders Know That You Don’t

As time and technology march forward, our quality of life really does improve. That’s why there will be a great deal of approval and appreciation from millions of investors and traders a few years from now, when they wake up to the jaw-dropping reality that Yes! You really can invest better and more profitably by taking advantage of the “new” science of investment psychology!

This realization has been slow to take root. But today nearly every top investor and stock trader readily admits that success in the stock market depends as much, or more, on who you are and how you make decisions than on the specific stocks you select. Relentlessly, this insight and understanding will trickle down through the various echelons of traders until even the most optimistic college undergrad and the least sophisticated Beardstown Lady will no more consider making investment decisions without attention to psychology than they would consider trading stocks without an online account.

The reason is so obvious, we should have seen it years ago: investing is a risky business – far riskier than most other daily decisions or possibilities we encounter. For example, most purchases are for relatively small sums. If you buy something that turns out to be totally worthless, and for some reason you can’t take it back for a refund, you’re out only a few bucks. Maybe a few hundred. Buying a car? You’re protected by warranties and by “lemon laws.” Even if your house burns down, you’re insured.

But there’s no protection or safety net for those who buy and sell shares of stock. To have a chance for a significant gain, you must accept the possibility of a significant loss. And the minute you open yourself to that risk, a whole new and unfamiliar set of emotions come into play. That’s why your real-world investment activities and bottom-line results are as much wrapped up in psychological issues as financial ones.

Fear and greed are the two most commonly talked about emotions involved with investment psychology. But there are many more: hesitation, self-doubt and overconfidence, ego and issues of self-worth. The list goes on and on.

The vast majority of participants in the stock market generally have not been told, and so they rarely recognize what all savvy, successful traders and investors know: your own psychology is the single most important factor in generating and holding onto stock market profits.

That's why so many of us know what we should do in the markets, but somehow we don't do it. We hesitate. We deny. We succumb to strong emotions that overpower our rational mind. If we survive in the markets long enough, of course, we eventually come to understand the importance of personal psychology. But why should this be one the of last things we recognize and understand? It should be one of the first!

Clearly, success in the markets requires knowing when and how to invest. But that's not enough! You must also be able to follow your intentions and your plan. It’s easy in practice, but very difficult when you’re under the serious emotional pressures that come with having real money on the line, and with the market acting as unpredictably as it usually does. This is why ""investment psychology"" is so critical for people who want to make money in the markets, and keep it.

Consider These Scenarios

Here are a few scenarios to consider. See if any of them explain your own investment or stock trading experiences:

I’m Not Worthy: You’ve had some good trades in the market, and your account balance is up – way up – from where it started. Some traders have generated more in a month than their parents earn in a year. Others have found themselves with lots more income than their neighbors, friends, and relatives.

But then your trading acumen abandons you. You give up on winning stocks too early. You back losers or take the wrong side of what could be successful trades. Or perhaps you simply can’t maintain your sense of conviction about what to trade, and when to trade it.

From the outside, it appears that you’ve run into a streak a bad luck, or your trading strategy has begun to work less effectively. But if you look deeper, you might see that your success has simply been dialed back to a level at which you’re much more comfortable. Coincidence? Or something more?

I Can’t Be Sure: All indications seem to point to a profitable opportunity in the markets. But you hesitate. You’re not 100% confident. You rework your analysis, once, twice, several times. You look for corroboration. You ask other people their opinions. In the end, you let the opportunity pass you by.

An objective observer might suggest that some opportunities are less desirable than some others. But if you introspect, you might catch a hint that you’re simply hesitating at precisely the time when a crisp decision is called for.

Damn The Torpedoes: It’s Admiral David Farragut’s famous battle cry, and historically speaking, the decision to risk everything for an important victory during the Civil War battle at Mobile Bay worked out very well. But when you’re risking money in the stock markets, allowing yourself to get caught up in the moment and take on more than a prudent level of risk is almost certain to get you burned, sooner or later.

Many people unconsciously adopt a “damn the torpedoes” approach after either a big loss or a big gain in the markets. After a loss, you might hope to win it all back or even get ahead. After a gain, you might feel impervious to market forces. Either way, there’s a possibility you’re letting your emotions crowd out your more logical, sensible self – always a bad idea in the markets.

I Want It All: You’ve got a big winner in your portfolio, and you’re wondering whether to let it ride or take some profits off the table. When greed is in the driver’s seat, though, you’re likely to ignore indications that the trend is slowing or the move is completed. Instead, you may focus on how much more you might be able to take out of the position. You will often hope that waiting a little longer will prove a lot more profitable. Too often, your greed makes you start giving back some of what ought to stay into your account. It could all be due to an unlucky turn in the market. But there’s a significant chance it’s a triumph of emotion over logical decision-making.

I Know I’m Right: The act of placing a trade is more than a leap of faith. It’s a testament to our confidence in our own judgment. But inevitably a certain percentage of trades go wrong, and when they do, ego can propel us to stay in when the prudent investor would get out. We may simply have made a mistake. But it’s possible our emotions have convinced us the market will turn in our favor, or have made us feel sure we need only wait a little longer to see our original judgment borne out, or have triggered a hope that we can get away without admitting we were wrong.

The Remedy: Get Your Mind Right

There are many emotional and psychological pitfalls awaiting unwary, untutored investors who haven’t yet learned the role of psychology in producing and maintaining investment success. But the remedy for all of them is fairly straightforward, although it requires a desire to improve and a long-term effort to sink in and take effect.

Simply put, you must learn the ways in which your emotions can play too large a role in your investment decision-making, and you must develop a degree of emotional control and self-discipline that keeps you taking the most prudent investment choices instead of the emotionally-satisfying ones. Accomplishing this is not particularly difficult. Most people can do it. But it does take time and effort.

For example, many traders know exactly what they want to do in critical situations. But it’s only the successful traders who actually follow through and do it. The rest don’t, mostly because they freeze. The disciplined approach is to increase your position sizes slowly, so you’re emotionally comfortable at the levels you’re trading, and also to consider your alternatives in advance so you know what to do, without having to think on your feet, in response to every market eventuality.

There are many psychologically savvy traders who believe you will not be able to make and hang onto significant success in the markets unless you are prepared to handle big money and heady levels of freedom and power. This kind of preparation includes: trading only with money you can afford to lose, thinking in terms of percentages instead of actual dollars, and working to take your satisfaction at least partly from trading according to your plan, rather than purely from generating profits.

With the pressure and the high stakes involved, even the most well-adjusted trader can sometimes succumb to anxiety attacks. But this interferes with following your plan, greatly diminishes your emotion control, and seriously disrupts your trading. To prevent this, psychologically sophisticated investors and traders work to develop their relaxation techniques, and practice them regularly before, during, and after the trading day. They also pay close attention to reality factors, and let the fantasies sent forth by their anxieties wither on the vine. One good approach is to stay focused on day to day issues, such as what setups to take, where to exit, and how to control your risk. Finally, they learn to recognize when their instincts or subliminal perceptions are telling them correctly that something is amiss, and to temporarily step back from trading to deal with the issue.

As this psychological awareness and “know how” continues to develop and become more widely known, there’s a good chance that even the least active traders and investors will begin to recognize how to free themselves from the tyranny of their own emotions, and trade on a more even playing field with the “big boys” and the so-called “smart money.”