The Complete Guide to
Investing & Trading Psychology
(Update in progress – ready in a few days!)
In this guide on trading psychology, you will learn:
Looking for a particular topic? patience & discipline managing losing trades mental agility managing winning trades circle of control building confidence behavioral biases practical applications
Chapter 1:
Introduction to Investing & Trading Psychology
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Now, let’s get started with the basics!
In the game of trading and investing, the goal is not to make once-off huge bets and have large swings in your portfolio based on your luck.
The ultimate goal is to achieve consistent returns over the long-run.
And to achieve this consistency, traders will not only need to have a good trading plan, but will also need to master the psychological and mental aspect to be able to execute the plan flawlessly over and over again.
Your mind is your greatest asset, and also your greatest enemy.
Hence, you can think of consistency as a state of mind, where despite the outcome of any trade (win or lose), and despite your current mental state, you can continue to perform and execute your plan in a consistent manner.
Consistency = Repeatability
Repeatability = Scalability
Scalability = $$$
If you want to make it big, and trade a large trading account, you first need to master trading a small account.
If you can consistently trade a small account, it means you can repeat the results and performance onto a larger account.
So this will allow you to scale up, and trade a larger account.
If you try to scale up without consistency, then you will see large swings in the capital of your trading account, and it is only a matter of time before you blow the account.
So how can one master trading psychology and achieve the ideal mental state?
In the next few chapters, I will cover some of the essential traits that traders need to have, as well as the different areas of trading psychology that traders need to master.
Chapter 2:
Patience & Discipline
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Wait for the best opportunities
Do not chase a missed trade
Better to miss the boat then to leave on one full of holes
A good entry allows easy risk management
Avoid impulsive trading (too frequently) and revenge trading (ego trading)
Chapter 3:
Managing Losing Trades
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Given a choice, which would you pick?
Sure profit of $1,000, or
50% chance of $2,000 profit, 50% chance of $0?
Given a choice, which would you pick?
Sure loss of $1,000, or
50% chance of $2,000 loss, 50% chance of $0?
Ability to accept losses
Stick to you plan and your rules
Define and accept the risk (SL) beforehand
Get out when the loss is still small
Do not average down and hope to breakeven
Read more: The Psychology of the Stoploss – Why is it so Hard?
Chapter 4:
Mental Agility
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Trade what you see, not what you think
Being objective despite having open positions
Anticipate, but only act when market confirms your opinion
When you see danger, get out first!
Clear all positions to have a neutral frame of mind
Chapter 5:
Managing Winning Trades
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Do not take profits until there is a good reason to do so
The Chicken parable
Do not count your profits until they are realised
Accept that you will have to give some profits back to the market
Do not become complacent or greedy after a huge windfall or winning streak
Chapter 6:
Circle of Control
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Focus your energy on what’s important
Letting go of the outcome
You cannot control the outcome, but you can control your actions and emotions
Do not focus on the $ and P&L fluctuations
Sports analogy: Don’t focus on the score!
Big picture: individual trades do not matter
Read more: Is Trading really Risky like Gambling? (How to Trade Like a Casino)
Chapter 7:
Building Confidence
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Success breeds confidence
Baby steps to giant strides
Confidence in your (i) ability (ii) system
Hesitation to pull the trigger
One more bar syndrome
Burnt finger anxiety
Mental reset – one good trade!
Chapter 8:
Behavioral Biases
In classical finance, traders and investors should always make rational decisions to maximise their self-interests, but in practice, quite often they end up making decisions that are not always rational, due to the influence of emotions and cognitive biases.
There is a whole (relatively new field) of finance called behavioral finance, which seeks to understand why this happens.
Now, let’s get started with the basics!
Behavioral finance is the branch of finance that combines classical finance (rational decision-making) with the psychological/behavioral aspect of market participants.
In layman terms, classical finance tells us what people should do, whereas behavioral finance tells us what people actually do.
The main reason for this difference is that classical finance assumes that humans are rational decision-making robots, but in reality humans are subject to emotions, flawed thinking, cognitive biases, etc.
If you have tried trading in the markets, or even played a game of chance like poker, you will know how hard it is to make rational decisions once money is at stake, and greed and fear starts to cloud your judgement.
To help traders and investors overcome the problem of emotions in decision-making, the first step is to be aware of the situations in which we might exercise flawed thinking, in the form of cognitive biases.
Cognitive biases are systematic errors in thinking that affect the decisions and judgments that people make, so they might think they are making logical and rational decisions, but in reality they are not, because the thinking/deduction process is flawed.
In the following chapters, I have listed out various common cognitive biases, and simple steps which traders and investor should take to avoid falling into the trap of these biases.
Once you are aware of these biases in your decision-making, it would be easier to find ways to avoid or overcome them.
Chapter 9:
Practical Applications to Trading
Knowing all the different cognitive biases and dangers of emotional decision-making can make us more aware of whether we are thinking logically and making the right decisions.
But it can hard to be on 100% alert all the time, especially on stressful days.
So, what are some of the simple habits we can cultivate to eliminate or reduce the risks of cognitive biases?
Read more: Why Paper Trading is a Waste of Time (And What are Better Alternatives?)
Read more: How to Craft a Winning Trading Plan (The 7 Key Ingredients)
Read more: How to Create a Trading Journal (And Discover Your Edge in the Markets)
Read more: 5 Biggest Day Trading Mistakes that Beginners Make
Conclusion
I hope you have enjoyed this guide on how to tackle behavioral cognitive biases.
Now I’ll like to hear from you: what is your key take-away from this trading guide?
What of these biases are you struggling with the most?
Which do you think will have the greatest impact on your trading results if you manage to overcome it?
Are there any other behavioral biases that we have missed out?
Let me know by leaving a quick comment below right now.
Very insightful guide on how one thinks when making decisions for trading. I didn’t know there are names for such ways of thinking.
You’re welcome! These ways of thinking are useful not just for making trading decisions, but also can be used for making any decision in life!
Hi! Maybe you can teach how do we go about using the sufficient data for evaluation and testing? Maybe you can do a guide on that?
I’m not quite sure what you mean by “using sufficient data for evaluation and testing”, could you please elaborate on that? Thanks!
I think he means how much data do you need to evaluate and do back testing?
I agree that your mind needs to be as objective and neutral during trading. It is as important as your trading skills. I am a scalper btw. So this applies even more to me.
You’re welcome! I would say staying objective is important whatever the trading style is (swing trading, scalping, trend-following, etc), but for shorter timeframes like scalping, decisions need to be made faster so it can be more challenging. Keep up the good work!
So which cognitive bias affects you the most when you are starting out?
It really depends on the personality and psyche of each individual. Different people can be “immune” to some biases, while very susceptible to other biases. If we look at the most common issues, it will probably be loss aversion and anchoring, making it hard for people to cut losses.
Appreciate your response! Yea, I am quite affected by loss aversion personally.
You’re welcome!
Is Gambler’s Fallacy considered a cognitive bias?
I pretty much think so. It stems from a lack of understanding of how probability works. The probability of one independent event does not affect the probability of another independent event.
Yes. I think A LOT of people do not really understand how probability works. I think you can cover a topic on this. It will be useful. hopefully it will be simple for layman like me.
You are welcome! Actually, we have started creating some short videos on probability on our Tik Tok channel.
Is the knowledge of probability required to trade better? I am horrible at maths.
Don’t worry, you only need a very basic knowledge of probability to understand the risk management part of trading.
What is the estimated percentage that psychology plays a part in being a great trader? I read some guides that a good trader is emotionless.
It’s really hard to give a number for this, but if I had to estimate I would say about 60-70% of trading is executing your plan with the correct psychology.
No wonder mindset covers 60% of the success of a trader!
“Win as though you were used it to, lose as if you enjoyed it for a change.” – Ralph Waldo Emerson
A perfect mindset!
Agree!
That’s right!
I agree too! It applies to daily decisions that you make everyday. Took me by surprise how many thoughts we go through daily. And I also heard defensive mechanisms. But I guess that doesn’t apply to trading.
I think loss aversion might be a psychological defense mechanism.
Hindsight Bias is probably the most common. Its supposed to be helpful though, thats how we learnt from mistakes.
That’s not true actually. Experience is how we learn from mistakes, whereas hindsight bias gives us the illusion that we would have acted differently before given the information we know have after the event has occurred. But before the event occurred, there is no way of knowing the outcome of the event.
WOULD YOU RATHER BE RIGHT, OR AVOID BEING WRONG?
So philosophical. Do you want the glass to be half empty or half full?
Do you want to make money or don’t want to lose money? 😛
Great to see that psychological topics that I learnt in uni is being applied in trading too!
How about self-fulfilling prophecy? Does it constitute as part of the trader’s mindset? If you don’t believe you can do it, you might end up sabotaging your own trades?