The Psychology Of Trading And Investing
There exists a clear relationship between our psychology and the way we make financial decisions. Given that traders and investors face considerable risks on a daily basis, it’s important for them to take into account how the market can affect their mental states and vice versa. Brett Steenbarger, a psychologist who works mainly with stock market professionals, recently explored this issue in a column on Forbes where he offered helpful advice on how to stay mentally grounded when dealing with risky trades and investments.
While the stock market is not necessarily a gamble, it can definitely feel like one. When things go our way, we tend to push for even more profits, thinking that we can milk out even more from a winning situation. However, in Steenbarger’s experience, those who push too aggressively often set themselves up for losses that could otherwise have been easily avoided. Conversely, those who accept the win but also take the time to “restructure their positions for better risk and reward” can help establish a healthy frame of mind for decision-making moving forward.
Another way to keep your psychology in check is by diversifying your portfolios. Steenbarger compares the way in which short-term traders achieve diversification versus long-term investors—the former group often mixes in riskier varieties like “meme stocks” into their portfolios, while the latter group creates portfolios of research-backed assets that actually have the potential to move independently of one another.
Ultimately, the second approach ensures a balance of losses and gains, “allowing probabilities to work out over time and avoiding the ‘risk of ruin’ associated with concentrated positions.” Such a balance is crucial because when one’s profits and losses are stable, then so is one’s psychological state.
Lastly, Steenbarger suggests taking some time to step away from the markets to simply give your mind a rest. It can be easy to get lost in the numbers and trends on your screen to the point where it overwhelms your mind and makes it hard for you to make sound decisions. Given the intricacies of trading and investing, planning out a strategy is imperative to minimize the risks, and it’s challenging to do that when you’re under constant pressure.
“Portfolio managers I work with use much of their trading day away from screens, gathering information from colleagues and researching new ideas, fueling their intellectual curiosity,” said Steenbarger. “They are far less likely to burn out relative to those who spend chunks of their days staring at screens. We trade best when our egos are not wrapped up in profits and losses.”