One of my interests is 'psychology of trading.' It's a fascinating topic and understanding the basics (if there is such a thing) can truly help a trader perform better. The difficulty with that is recognizing that any of these principles applies to you. It's so easy to dismiss studies as being unrealistic. If not unrealistic, then at least the average trader has many reasons why the study does not apply to him/her.
We all want to make more money when trading, but many times traders inadvertently sabotage themselves by making decisions that they sense are not in their best interests. It's not deliberate. There's no attempt to prove to anyone that you can do it better than others.
It's often the result of being uninformed about the myriads of data that explains why some trading decisions are less likely to be successful than others.
One simple example is the size of one's trading account. Many rookies put together a very small stake ($2,000 or less) and begin to trade. The chances for success are just dismal. As yesterday's post of the risk of ruin indicates, the less money you have to trade, the greater the chances of losing your entire trading account. It's a statistical truth. But, it's also ignored.
Recently I read a very interesting research study (actually a blog post that discussed that study). It concerned why traders alter their behavior – depending on whether the most recent trade was a winner or loser. It would never occur to me to alter trade size, and thus risk, on anything as flimsy as that. However, when the sample being studied includes a large number of traders and a large number of trades, patterns emerge.
The blog was by the CXO Advisory Group. Much of what follows comes from their post, The original paper is no longer available online. .
The 6-month study (2006) covered more than 1.3 million Indian investors and 111 million transactions worth $85 billion. The details are available in the CXO post and the paper, but the interesting points to me are:
- Investors lost $2.3 billion
- Investors with positive past trades – trade more often
volume is 7.7% higher for traders with recent gains than for those with losses
- The probability of increased trading volume is 1.7%
higher for an individual with recent gains
- The sign (+ or -) of recent outcomes explains 89% of the variation in
subsequent trading frequency
- On average, profitability of current trades is almost 60% lower for
traders with recent gains rather than losses.
- The more successful individual investors appear
to be those less influenced by the signs of recent trades.
Bottom line: The sign (much more than size) of recent trades influences future trading behavior
of individual investors. This influence hurts overall
This is the typical situation that I find so interesting. Something minor, such as a winning trade, influences some traders to make the next trade larger. The real question is why the ensuing trade loses so much more often.
It may be the result of being anxious to trade again, resulting in a poor choice of trades. It may be that overconfidence ruins risk management. There's no way to discover the answer. The takeaway from this discussion is that mindsets can be altered by seemingly minor events. It's important to pay careful attention to your trading plan (if you have one) and make every effort to avoid allowing emotions to affect your decisions.
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April 13, 2010 5PM ET
Mark D Wolfinger
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