Behavioral Economics Can Explain Most of Your Trading Mistakes

Yes, this has the potential to sound like a college term paper, but hang in there.

This is a subject that you need to know about before you make any more trades. It’s the reason that some (if statistics are true, we should say, “most”) of your trades are leaving you wondering what went wrong. It’s a relatively new field of study called behavioral economics.

The basic premise goes like this: Every life experience you have is put through various filters before you decide what it means. If you’re dating somebody not long after a difficult break-up, you’re likely to be skeptical of that person. You don’t have a logical reason to feel that way but your judgment of that person is put through the filter of the failed relationship.

The same thing happens when you trade or invest. When you analyze a stock, every line of balance sheet, every candlestick of a chart, and every Benzinga article is evaluated through a series of filters before you decide to move on or commit money. If you learn to recognize these filters, which experts called behavioral biases, you can correct for their effects and improve the quality of your trades. Here are a few.

Overconfidence

Overconfidence manifests itself in a lot of ways but one of the most common is overtrading. The textbook definition is that you believe you have talents or information that give you an edge on the market. Your information allows you to move into a stock at the perfect entry point and exit just before it corrects.

The problem is that research shows this not to be true. A study of 10,000 clients at a discount brokerage found that when one stock was sold and another purchased, the purchased stock underperformed by more than 5 percent over a one year period. In other words, over trading leads to underperformance. If the trader held the original stock, they would have likely made money.

Regret

Is there anything in your life that you wish you had done better or not at all? Regret eats away at all of us and because of that, our mind takes conscious and unconscious steps to shield us from those negative feelings.

Is there a stock sitting in your portfolio right now that is down so much that if you sell it, you’ll book a large loss? Behavioral economists would tell you that the reason you refuse to sell is because right now the stock has a chance of bouncing back but selling it makes the loss real.

In other words, you would rather lose more and more money to avoid making your regret real. Selling would allow you to put that money to work in a better stock but the feeling of regret is too powerful.

How do you Control these Biases?

You control them by setting hard and fast rules that never change while the trade is on. In the next post we’ll look at a few more of these biases and how to set up trading rules to minimize their effects.