Trading Psychology Flashcards
Efficient market hypothesis (EMH)
Where prices are always a true reflection of all information available and therefore it’s impossible to put perform the market. It has been the basis of academic teaching for decades
EMH assumptions
- people act rationally and consider all available information before making decisions- WRONG
- people are unbiased in their predictions- WRONG
- all people are affected by psychological biases
Psychological biases
The brain uses shortcuts and emotional filters to shorten analysis time. Once focused in one direction, the brain may filter out other important information
Types of Mental accounting
House money effect
Snake bite effect
House money effect
Cause: a big unexpected win or series of wins
Effect: overconfidence and tendency to gamble
•you must integrate profits immediately with your overall fund
•this money is your money now
•casinos rely on this behaviour to make profit
Snake bit effect
Cause: a big loss or a series of losses
Effect: fear of losing again makes you less inclined to take risk
Try not to abandon your normal strategy and aim to bounce back psychologically after a loss
Prospect theory
Prospect theory deals with how we ‘code’ outcomes. E.g locking in a profit vs avoiding making a loss, our attitude to risk changes in each situation
How does our perceived risk change depending on whether we are making a gain or a loss?
We are more distressed by prospective losses than we are happy with equivalent gains. We are willing to take more risk to avoid a loss than realise a gain. When sitting on a profit we are risk averse and take the profit early. When we have a loss we’re prepared to take more risk so we hang on and hope it recovers
Tips to manage your risk
Before committing to a trade set your stop loss and identify an honest and realistic target.
Learn to love to take losses and hate to take profits, that way your losses will be smaller and your profits will be bigger
Loss aversion solutions
Forget what you paid for any investment (sunk costs are irrelevant). Evaluate all holdings based on current potential for future gain or loss. Don’t check your investments every 5 mins.
What areas do men consistently overestimate their own abilities?
- athletic skills
- abilities as a leader
- ability to get along with others
- ability to beat markets
What are the three particular situations that can give you the illusion of control
Outcome of sequence
Task familiarity
Information
Outcome of sequence
Early positive outcomes give illusion of control. If your first 5 trades are winners you feel like you are in control and this leads to overconfidence
Task familiarity
The more familiar people become with a task, the more they feel in control of that task. You can execute trades quickly and easily but that doesn’t give you extra control over your decision making ability
Information
Because there is so much information available, this can give the illusion of greater knowledge.
