The Complete Guide to
Investing & Trading Psychology
(Update in progress – ready in a few days!)
Introduction to Investing & Trading Psychology
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.
Patience & Discipline
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)
Managing Losing Trades
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
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
Managing Winning Trades
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
Circle of Control
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
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!
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.
Practical Applications to Trading