The Play of Primary Emotions on Trader’s Mindset
Previously we have learned the differences between the investor's and trader's mindsets. Let us now understand the primary emotions that affect the psychology of a trader.
Stock markets can be very volatile at times and can get the best of your emotions. As we discussed, a trader is one with a higher risk appetite due to the higher uncertainty involved. This invariably enhances the role of the four primary emotions: fear, greed, hope and regret that grapple a stock market participant.
We mentioned earlier how traders often act on “news” which may or may not be directly related to the company. Now, bad news about the economy, in general, will obviously scare a bullish trader. But what should his/her immediate reaction be? Should he/she liquidate the position and sit on the cash, waiting for the economy to recover?
To the naked eye, it may seem as though he is avoiding monetary losses but there are two factors that are not being taken into consideration here and they are:
a. Transaction costs - expenses incurred in carrying out a transaction in the market.
b. Opportunity costs - costs in the form of potential benefits that a trader foregoes when he chooses one alternative over the other .
He should first analyse whether liquidating his position is the only and most profitable option ahead of him and for that he needs to ask himself the following three questions:
- Reflection of a negative event on price: “Is this bad news going to re-adjust prices significantly or has the market already adjusted for this bad news in advance?”
- Capability to change strategy: “Is he capable of changing his bullish strategy and turning into a bear? If yes, will it be the best course of action?”
- Contrarian strategy: “Can he leverage this bad news to his advantage by buying at a low (since everybody else is selling) and then selling as soon as the market recovers from the shock?”
Questioning oneself before taking an impulsive action is what will enable one to have better control over their emotions when trading in the market. Traders must quantify this fear in advance (i.e., before the event takes place that will have a negative impact on them) and devise a plan of action ahead of time. This will ensure that no action is taken in haste at the time of the negative event, thus minimising losses to the trader.
Greed is not an easy emotion to overcome. It is human nature to hold on to your winnings to win every last penny that is possible. In a bullish market, this tendency of a trader enables him to earn big wins but in a bearish market, it leads to untenable stock positions.
The only way to combat greed to some extent is by showing discipline in your trading strategies. Discipline comes by way of setting mental rules and following them when in dire straits. E.g.: Setting a profit target or a stop loss.
Hope is very similar to greed with the slight difference that it causes one to hold on to their losses hoping for a reversal and some relief henceforth. Most people are too proud to admit that they have gone wrong and are thus able to accept their losses. Falsely believing in their original strategy and skill, they do not exit their positions further magnifying losses.
Let’s take an incident from the past to understand this emotion even more clearly. Even when technology stocks had started dipping in early 2000, showing early signs of the dotcom bubble burst, investors continued to get their hands dirty in those stocks. It eventually led to a brutal crash of the NASDAQ index whose effects lasted for years to come.
This is a feeling which I am extremely familiar with. I would like to explain this emotion with my very own example of holding a certain stock.
I bought SRF Industries in Dec 2017 at ₹1981 and sold it in April 2020 at ₹3725. At the time, I had made gains of 88% and was extremely content with my profit level. Now, the selling decision was not completely my own. My family badgered me continuously at the time to exit the stock for they thought there were better opportunities available in the market then. I still believed in the fundamentals of the stock and wanted to hold on to it for longer. But seeing the profit then, I was scared it would dip as that was the overall sentiment of the market due to the spread of the COVID-19 virus and imminent lockdown. Hence, I succumbed to my family’s suggestions thinking I will buy the stock later when the price goes down. Since then, SRF Industries stock has been unaffected by the pandemic and on the bull run. Today (as of April 2021), it is at ₹6156. Almost every few weeks, I see the price of the stock on my watchlist and my heart is filled with “regret”. I cannot help but get affected by the so-called “fear-of-missing-out”.
You might wonder how greed is different from regret? Greed is what makes you hold on to your “current” stock position in hopes of bigger gains and smaller losses. On the other hand, regret is what you experience after exiting your “past” stock position.
A consequence of regret is that it often makes traders enter into a position after the window of opportunity has closed. In my case, I did not act on it as my initial strategy after selling SRF was to buy it only when it falls and then I couldn’t get myself to buy it at such a high price. However, even that is wrong because it was not a well-calculated decision. As a long-term investor, I should have calculated the company’s true value (either using a comparable approach or discounted cash flow methodology) and then held on to the stock till my target true value reached.
Moreover, once you have sold a stock after it reaches your target value, there is no point expressing any sorrow (or regret) if the stock price further rallies. This is because it is important to realise that no individual can “predict” the exact high of a stock or the exact low. So, it only makes sense to hold on to something until you deem it to be the maximum value it is worth attaining.
Another learning from my story is that a stock market decision should always be your own. It is okay to take advice from people but until you are convinced with the advice and find that advice to be the best course of action at that point in time, you should not act on it. Otherwise, you will exhibit something called attribution bias – a cognitive bias where you tend to attribute your winnings and successes to yourself and your losings and losses to other people or external factors. We will discuss in detail a myriad of behavioural biases in the subsequent sections.