The human mind is not built for financial business. Our archicortex (the oldest region of the brain’s cerebral cortex) can’t distinguish between life-threatening and non life-threatening situations. This has effects throughout the financial sector, especially trading. Unfortunately, the perfect rationality of the “homo economicus” is a lie: humans have always been known to be affected by emotions and biases. Richard Thaler, a Nobel laureate in Economics, argues that this guarantee of irrationality is ironically the most rational way to understand financial decision making. The mere prospect of making money releases dopamine in our brains and the fear of losing it can be overwhelming. De facto it can be said that humans are creatures dominated by emotions. However, these emotions can be manipulated to maximise profits (this area is generally called behavioural economics).
Although traders claim that they make decisions in a wholly rational way, in truth they are often impacted by biases – subconscious methods of thinking caused by mental shortcuts. These biases impact how traders approach problems. One of the most prevalent biases is the “Loss Aversion Bias”, which is linked to our fundamental fear of losing that which makes us happy. It is best encapsulated by Tversky and Kahneman: “losses loom larger than gains.” It is the preference of avoiding losses over acquiring equivalent gains. So how does this affect traders? Unfortunately, loss aversion impacts how the trader makes decisions. The bias causes traders to focus more on the potential costs and losses, rather than the potential for greater profit. This could lead to significant loss of opportunity simply due to the fear of losing money. In addition, traders can hyper-focus on one investment and not take into consideration the profitability of others. Moreover, it can lead to traders not selling their assets at a loss, even if it is rationally the correct decision. Thus they can plummet even deeper into loss. It can seriously impair a trader’s judgement: it is a common mistake not to let winners run and to cut one’s losses, as summarised by L.R. Thomas.
Another crucial aspect to behavioural economics and the role of psychology in trading is the concept of personality, which, in trading, is defined as the combination of characteristics that devise a trader’s identity. The trader’s personality predisposes them to certain behaviours and methods. Although there are five key areas of personality (discipline, decisiveness, patience, rationality and confidence), I believe that the most important one in relation to trading is patience. Patience encompasses not only waiting for the appropriate time to enter/exit the market, but also waiting for investments if they don’t immediately bear fruit (sacrificing immediate gratification in the hope of a future benefit). 66% of participants in a recent survey engaged in financial investment as they thought it more profitable than saving money. But with no patience, it can cause losses that are easily preventable. A different study conducted by Freeman-Shor suggests that only approximately 21% of the stock investments realised a return of over 100%, partly because some of the participants did not have the patience to wait for the trend to run and thus settled for a smaller profit instead of risking what they had already gained. This is a form of the aforementioned Loss Aversion Bias, as it highlights the importance of not “snatching” profits, but rather of viewing the bigger picture, in order not to miss out on a substantially greater profit. This is known as the “disposition effect” (coined in 1985 by economists Shefrin and Statman).
Building on the previous points, emotions are a crucial and inevitable part of trading. One emotion specifically has a great impact on trading: fear. It is usually caused by the threat of loss, whether real or imagined. A study by Lee and Andrade has shown that, after being exposed to clips from horror movies, 55% of participants wanted to hold on to their stocks. However, in a group that wasn’t shown the clips, the proportion of participants wanting to hold on to their stocks increased to 75%. Despite this, fear is a very primitive response which can be used to the trader’s advantage, provided that it is not overwhelming, as it can sharpen analytic reasoning. The impact of fear is especially prominent in less experienced traders, as, with more experience, traders become aware of the damaging effects of fear on decision making.
Lastly, traders are affected by social pressures. These are external factors which directly influence a trader’s psychology, leading to unnecessary risk. Specifically, competition significantly impacts a trader’s mentality and can lead to losses. This can, for example, be the desire to make more money than the person beside you. Nonetheless, it is important to have patience, discipline and to follow one’s own plans. A study by Dijk suggests that a trader is 50% more likely to enter a risky situation when colleagues are present than when he is placed in an isolated chamber. This highlights the impacts of peer pressure. Competition is an issue because there is a fundamental human need to be the best. This could force traders, especially less experienced ones, to enter a situation that they are uncomfortable with and hence lose money. However, with experience and control over jealousy and emotion, a trader can use competition to push himself even further and hence maximise the profits made. Although human nature and emotions can hinder potential profit, traders can use these factors to gain a better understanding of the market and realisation of profit opportunities. In this way, our bounded rationality can actually have a positive effect on traders.