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Trading psychology
Why investors shouldn’t trust their own judgement
By Toni Case
A friend of mine works for Google, and was fortunate enough to be given thousands of shares in the mighty search engine just before it floated. She was lucky enough to receive options in the tech stock that today, just two years later, sits at a whopping US$740 a share. It was a stroke of good luck, a once in a lifetime experience, but if she doesn’t analyse her personal trading psychology, this good fortune may lead her astray.
We all carry around past investing experiences, both positive and negative ones. Like a guidebook, these experiences, beliefs and assumptions about the world around us, guide our decision-making. Do you buy the house in Manly, or the new-beaut hedge fund? Do you leave your money in a term deposit, or use it to leverage into a share portfolio? Have you ever analysed why you make one decision over another? Most of us don’t.
Indeed, good and bad times on the sharemarket, or any investment for that matter, will impact the decisions we make in the future. Let’s say that the first float you participated in generated a mind-boggling 200% return. Based on this positive experience, it’s likely that you will throw future savings into floats without giving the investment the scrutiny it deserves. By failing to properly analyse the underlying company before it lists, the returns you receive are likely to disappoint.
On the other hand, let’s say that your first investment was on a tech stock that plummeted down its price chart the week after you bought it. The loss, searing a hole in your bank account for the next five years, sets into action an overwhelming fear of losing money. As you cautiously move back into the market you find yourself repeatedly jumping onto stocks too late and missing out on significant gains.
It’s difficult to pinpoint the origin of particular beliefs or assumptions that we cling onto. Are they the opinions of our parents, television reporters or journalists? Or do they originate from advertisements, a teacher, or friends we admire?
When I was young, my cousin lost a bundle of money on the futures market. Relaying the story, my mother told me that futures trading is risky and losses can mount quickly – almost like a running tap that can’t be turned off. I’ve dragged this belief around with me without questioning it, and it’s not surprising that I’ve continued to steer clear of this supposedly risky derivative.
The best investors and traders in the world are almost guru-like, with meditation and mind control as highly regarded as their trading software or system. Successful investors know that their judgement is often flawed, biased and subjective, and if they don’t work at ironing out these flaws they will forever make poor decisions. And poor investment decisions translate into poor returns.
Unsuccessful investors, on the other hand, lurch from one ad-hoc investing experience to the next, blind to the fact that they’re not really making a choice at all. Almost on automatic pilot, these investors fall into similar patterns of behaviour. As an example, a well-entrenched view amongst Australians is that property is safe. How many people do you know that purchased property at the tip of the property cycle? Rather than objectively looking at the fundamentals of the property market in late 2002 – interest rates were creeping up and home loan affordability was at an all-time low – many investors made purchasing decisions, some of which may come back to haunt them, based on the underlying belief that property is safe.
Have you ever questioned why you often overspend using credit, but are always careful with your savings? Or why you are quick to hit the sell button on a share that has made you money, but at the same time continue to hold loss making shares? According to a Nobel Prize-winning theory called Prospect Theory, the average investor is risky with losses and conservative with profits – usually to their detriment. Indeed, this natural tendency goes against one of the prime axioms of investing: cut your losses short and let your profits run. How can we therefore be trusted if our innate tendencies are to make irrational decisions?
The big question for many investors and traders is how to making winning investment decisions. Unfortunately in today’s instant age of communication – of streaming news and data, not just locally but internationally, one’s ability to become successful is declining, not improving – and unfortunately at a staggering rate.
French economist Georges Anderla outlines our dilemma perfectly: Anderla’s statistical model demonstrated that information flow doubled in the 1500 years between 1AD and the time of Leonardo da Vinci, it doubled again in the 250 years to 1750 and again to the turn of the 20th century.
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