When price movement bothers you while you sleep and causes you dreams of paradise or nightmares, you are suffering from the real capital market crisis. It is easier said, but if you can’t keep cool in markets, you are at the wrong place. Markets need a lot of detachment if you really want something constructive and valuable to come out of the vocation. How can one detach from profits and losses? If you think you are getting complacent, think again and tune up.
“The market does not beat them. They beat themselves,” stated Jesse L Livermore, a stock trader from the beginning of the 20th century, known for making and losing several multi-million dollars during the major stock market crashes (1907 and 1929). Traders are human beings above anything else and behave accordingly. More often than not, our behavioural errors interfere with our cold-minded trading and distort our thinking. “This time it’s different”, “This time we know better”, “We will not make the same mistakes again”. How many times do we hear that in the trading world? And yet the same behaviour repeats itself over and over again, in different times and different shapes, but with the same substance.
Behavioural finance has gained a lot of ground over the last decades, mainly because analysts all over the world realised that the main driver of the prices (supply and demand) is human psychology. The aggregated trader mentality is far more complex than we can imagine and the study of it revealed interesting aspects, proving that usually it is not as rational as we would expect it to be. It teaches us important facts about how humans differ from traditional economic assumptions.
How does the mind of a trader work?
In order to understand behavioural finance and crowd behaviour on the capital market, we need to understand the factors that influence the trader mindset. As Jeffrey Kruger, a senior writer at Time magazine and the author of Simplexity would say, traders are “misled” by many things. Let us put these factors in two main categories, depending simply on their source, external or internal. The most important external factor is “everyone else”, the trading crowd, the general opinion. We form an opinion about others. We believe them to be either smart or stupid, either right or wrong, then choose one of the two main psychological trading strategies: “go along to get along” or be a contrarian. Then we have other external factors like payoffs, scale, psychological and academic background, social structure, external advisory and resources.
Maybe the most misleading and yet powerful internal factor is the trader instinct. “My feeling is “I am sorry to say, but that feeling of yours is not quantifiable”. Intuitions are good but they are not a system. Whom do we trust more than ourselves, our own hunches, past experience and well-learnt lessons? Overconfidence is by far the most common behavioural error and can lead to irrational decisions, dangerous trading and therefore, huge losses. This is the point where trading is a lot like gambling for a significant part of the players.
When trading becomes gambling
The fact is that most of the market players are attached to the idea of profits. We are in love with the capital market. Trading makes us feel alive. Even investing gives an aura of safety, but there is so little we know about markets that any feeling of safety is an illusion. After a certain stage, it is not about the money anymore, a bigger loss won’t kick us out of the market, we will return every time with the hope of winning. Sometimes the win does happen and develops into a powerful stimulation for further trading.
Other times we lose it all. Our love turns into hate or ignorance at least. Either way, it is an extreme sentiment, overwhelming or disappointing, but above all other things, ‘irrational’. Replace “trading” with “gambling” and there you have the kind of behaviour common in casinos. The stock market anomalies can be explained with our emotional extremes, over- and under-reaction, greed and fear and, as Robert Shiller (Yale) called it, “magical thinking”.
Isn’t this overconfidence and trading addiction the one that causes emotional extremes, bubbles and huge volatility on the capital market? How can a stock’s price move so far away from its intrinsic value if not influenced by emotional extremes and trader’s expectations? When bubbles develop, fundamentals fail and the mystic spirit of the market takes over. Shiller said that these are the moments when market players go a little crazy. How can we predict the degree and length of the madness?
How can we beat the market if we don’t understand human and market behaviour and the way this behaviour changes cyclically? If our behaviour is cyclical, then how do we break out of the cycle? Or is this cycle natural and the only thing we need is to time our reactions better? It would be extremely convenient to sell at a top and buy at a market bottom. The answer is not to change the cycle, but to synchronize our own calls according to the market rhythm.
How do we keep it simple?
So, how do we avoid all this madness? How do we “trade safe”? How do we maintain a healthy relationship with the market and not fall madly in love with it? Mark Twain said that “History may not repeat itself, but it does rhyme a lot”. On the other hand, a famous poker player admitted that “Poker is like life, most people don’t learn from their mistakes, they only recognise them”. Can we develop such a skill to analyse our behaviour and avoid repeating the mistakes over and over again?
Acceptance is key. We need to accept our bad calls and move on. Wealth is created by getting it right most of the time, not necessarily all the time. The aftermath of market crashes and crises should be valuable lessons for the future. Are we really capable of learning and keeping is simple?
With contributions from Mukul Pal, CEO,Orpheus Capitals, a global alternative research firm
