Last Updated on October 16, 2023 by BFSLTeam BFSLTeam
Investing or trading in the financial market is not merely about tracking the prices of shares and securities to plan your entry and exit. It is also about reading the market sentiment and modifying your trading strategy as required. The market sentiment is driven by the inherent biases and emotions of investors trading in its various segments. Collectively, we call this trading psychology.
If you understand the psychology of the traders collectively participating in the market, you can anticipate future trends more effectively. In this article, we’ll take a closer look at what trading psychology is and
Table of Content
What is Trading Psychology?
Psychology is the study of the mental state and emotional aspects of an individual. Trading psychology is, by extension, the study of understanding a trader’s mindset. It involves getting to know the inherent biases and emotions that drive your own trading decisions as well as the decisions of other investors in the market.
This is an interesting aspect to decode because, at first glance, trading comes across as a highly quantitative and objective activity. However, a closer look will show you that trading is also extremely qualitative and subjective — because it is influenced by the general market sentiment.
Why is it Important to Understand Trading Psychology?
Trading psychology directly affects your investment decisions. If the investor sentiment is bullish on a particular stock, it could drive the price upward. However, a bearish sentiment may be a precursor to falling stock prices.
Similarly, if the quarterly results of a company are due to be released, and if the investors have a positive outlook regarding the financials, they may increase the buying pressure. On the other hand, if the prevailing market sentiment is one of fear or panic about the results, the selling pressure may rise instead.
Additionally, apart from the general market sentiment, your own psychology and mindset also influence your trading decisions significantly. If you are afraid of falling stock prices, you may end up panic selling. On the other hand, if you are irrationally optimistic about a specific stock, you may take a long position in the company even if it is not fundamentally strong.
By understanding your individual trading psychology as well as the collective psychology of traders in the market, you can predict these patterns and prevent yourself from making impulsive or emotional decisions.
The Biases that Drive Trading Psychology: And How to Manage Them
Now that you know what psychology is in trading, you can better appreciate the common biases that trades are prone to. Check out these biases and what you can do to manage them.
- Availability Bias
Availability bias in trading psychology is the practice of making trading decisions based on certain information simply because it is easily available. Needless to say, doing this will lead to uninformed decision-making.
Managing Availability Bias:
The only way to avoid this bias is to take the time to research the stock you wish to invest in and look beyond easily available information.
- Anchoring Bias
Anchoring bias occurs when you tend to rely too heavily on a particular bit of information over others. In other words, you ‘anchor’ onto one detail. This will prevent you from factoring in other material information when you make trading decisions.
Managing Anchoring Bias:
You can avoid anchoring bias by actively conducting your own research and looking past the information you tend to prioritise.
- Confirmation Bias
Confirmation bias occurs when you tend to value information that confirms your pre-existing beliefs rather than weight data objectively. This will inevitably lead to biases in decision-making. For instance, you may ignore negative data about a stock because you believe the company is strong.
Managing Confirmation Bias:
To overcome confirmation bias, you need to evaluate information even if it conflicts with your preconceived notions.
- Hindsight Bias
Hindsight bias in trading psychology is the tendency of traders to believe that they knew something all along. However, this is not always the case, because some things seem more obvious in the future after new information comes to light.
Managing Hindsight Bias:
To avoid hindsight bias and the false sense of confidence it gives you, ensure that you keep a log of the factors that drive your trading decisions. This way, you know exactly what information you had and used.
- Recency Bias
If you are prone to recency bias, you will tend to value recent information over older data. While this may work in your favour sometimes, it may be a costly mistake at other times.
Managing Recency Bias:
To overcome recency bias, you need to consciously strive to gather older information and assess if it is material for your trading decisions.
Conclusion
This concludes the details of what trading psychology is and why it is important. To become a successful trader, it is essential to be aware of your own trading psychology, emotions and biases too. This will help you make objective trading decisions that are not governed by your impulses and emotions. What’s more, by understanding the overall trading psychology and sentiment associated with the market, you can get more clarity on the prevailing and potential price movements.
