Trading Psychology – Imperative Foundation For Success

Trading PsychologyAn understanding of Trading Psychology is the imperative foundation for all the other skills required for success in the financial arena.

The inability of the masses to endure the psychological effects imposed by the market is the main reason why Wall St eats them alive and why there is so much money to be made by the emotionally intelligent minority.  If you are aware of how psychology drives the market you can stand witness to it and maintain clarity of mind in the face of both jubilation and crisis.

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Psychology is probably the most important factor in the market – and one that is least understood. – David Dreman (Author of “The Psychology of Stock Market Success”)

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Studying Trading Psychology completely altered my definition of what the stock market is.  (Before this realization I nearly whipped out my entire trading account).  How you define the market defines how you approach it and the turning point for me came when I began to see the market through the following paradigm:

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The stock market represents the collective human emotional interpretation of all that is known and its subsequent effect on the supply and demand of shares in publicly traded companies.

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If it were not for human emotion then all investments would be perfectly priced, the markets would be efficient and it would be impossible to beat the average return.  In reality the market is driven by the twin emotions of Fear and Greed.  When prices are rising, greed is the dominant emotion.  When prices are falling, fear is the dominant emotion.  Notice that logic is not a factor in the equation.

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I’d be a bum on the street with a tin cup if the markets were always efficient. – Warren Buffett

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The market consists of two main groups; the Smart Money and the general public.  The general public ride on emotion and profit only by luck, while the Smart Money ensure they make decisions based on logic.  As a result the Smart Money consistently profit over the long term.

When logic and emotion come into conflict, emotion always wins.  If logic was the more powerful of the two then there would be no fat people.  Instead the logic of eating adequate portions of food selected on the basis of health and a long life is not as powerful as the feelings/emotions experienced by eating gluttonous amounts of food selected on the basis of taste and convenience.

Valuable insight into Trading Psychology can be gained by studying the market during booms and busts because these are the times when it’s effects are most obvious.  Huge groups of people will ignore their better judgment and seemingly go insane.  Do you remember the height of the Dot Com boom; Oct 1999 – Feb 2000?

This is from the prospectus of VA Linux’s IPO – November, 1999: (now SourceForge, Inc. LNUX)

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We incurred losses of $14.5 million in fiscal 1999 primarily due to expansion of our operations, and we had an accumulated deficit of $29.9 million as of October 29, 1999.  We expect to continue to incur significant … expenses…  We do not expect to generate sufficient revenues to achieve profitability and, therefore, we expect to continue to incur net losses for at least the foreseeable future.  If we do achieve profitability, we may not be able to sustain it.[1]

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Based on this information how would logic suggest the IPO went?

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Shares in VA Linux Systems soared eightfold today, setting a new record for the largest first-day gain of any initial public offering. – CNET News[2]

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A first-day price gain of about 700% and a closing price of $239.25[3] gave Linux a market cap of roughly $9 billion.[4] It went on to lose $728 million over the next 5 years before turning its first profit of $3.9 million in 2006.[5] On November 25, 2008 it closed at an all time low of $0.58

Can the market get any crazier than this?  You bet…  Is was revealed by a Purdue University study that during the Dot Com boom companies could get a 89% jump in their stock price simply by switching to a Dot Com name.[6]

The price of NEI Webworld, rose almost 1,170% in a day simply because it made news for its involvement in an Internet scam… NEI had no assets and was already in bankruptcy liquidation!![7]

In this kind of environment many people lose all self control, get swept up in their emotions and forgo the most basic due diligence into a companies fundamentals.  Like in 1999 when AppNet Systems, Inc. filed for an IPO under the symbol APPN, at the time there was a company called Appian Technology, Inc. trading on the NASDAQ OTC Bulletin Board under the same APPN symbol.  In a feeding frenzy people started buying shares of Appian technology thinking they were getting AppNet Systems before its IPO.  Appian Technology shares went up 142,757% in the two days following the filing.  Over 7.3 million shares were traded compared to just 200 shares the day before.[8]

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I can calculate the movement of the stars, but not the madness of men. – Sir Isaac Newton, lost a fortune in the South Sea Bubble

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Perhaps the most hilarious examples of the utter madness that humans are capable of when driven by greed were seen during the South Sea Bubble.  Capital was raised through stock offerings for, among other things; “a wheel for perpetual motion”[9] and “The trading of hair”.[10] But my personal favourite is a prospectus by one audacious con-man entitled:

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“A company for carrying on an undertaking of great advantage,
but nobody to knows what it is.”

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The man (who nobody has been able to identify) simply stated that the required capital was half a million.  Just 5 hours after opening the doors for the IPO he had raised £2000.  Then, that evening, displaying infinitely more intelligence than the people he had just robbed, he set sail for the new world (America) and was never heard from again.[11] He knew enough about the psychology of trading to see the bubble and prey on those blind with greed.

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Nothing sedates rationality like large doses of effortless money.  After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball.  They know that overstaying the festivities – that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future – will eventually bring on pumpkins and mice.  But they nevertheless hate to miss a single minute of what is one helluva party.  Therefore, the giddy participants all plan to leave just seconds before midnight.  There’s a problem, though: They are dancing in a room in which the clocks have no hands.[12]Warren Buffett

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This irrational behavior by people riding on emotion opens the door of profit to those that understand trading psychology.  Crooks use it as an opening for their underhand tactics but the lasting profits are to be enjoyed by emotionally intelligent traders and investors.

It is important to distinguish between the Psychology of the individual and that of the crowd.  It is not possible for large numbers of individuals to reach such extremes of irrational behavior simultaneously.  This only occurs when individualism is lost and ‘Herd Mentality‘ takes over.

What examples of madness have you witnessed in the the market?  Have you ever missed opportunities or made regrettable investments under the influence of emotion?  Share your experiences in the comments section below.

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Part 2 – Herd Mentality

Part 3 – Group Intelligence

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  1. ^ VA Linux Systems, Inc. IPO filed with the SEC November 17, 1999. Page 7; Risk Factors, Paragraph 2; We have a history of losses and expect to continue to incur net losses for the foreseeable future.
  2. ^ VA Linux storms Wall Street with 698 percent gain by Dawn Kawamoto and Stephen Shankland, CNET News December 9, 1999.
  3. ^ VA Linux storms Wall Street with 698 percent gain by Dawn Kawamoto and Stephen Shankland, CNET News December 9, 1999.
  4. ^ Meeting of the Federal Open Market Committee December 21, 1999. Page 12, Paragraph 2.
  5. ^ SourceForge Inc: Financial Statement, Income Statement – 10 Year Summary (in Millions).
  6. ^ A Rose.com by Any Other Name by: Cooper, Michael J; Dimitrov, Orlin; Rau, P. Raghavendra. The Journal of Finance, Volume 56, Number 6, Page 2379, Paragraph 1, December 2001. Department of Finance, Krannert School of Management, Purdue University.
  7. ^ In the wild world of Internet postings, sometimes bad news is good news by Rebecca Buckman, The Wall Street Journal, December 17, 1999.
  8. ^ Mistaken ID takes stock for a ride Briefly shared symbol caused AppNet mix-up by Terzah Ewing, The Wall Street Journal, May 9, 1999.
  9. ^ Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, Volume I, 1852 by Charles Mackay, LL.D. Chapter 2 The South-Sea Bubble, List of Bubbles, Page 58, #36.
  10. ^ Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, Volume I, 1852 by Charles Mackay, LL.D. Chapter 2 The South-Sea Bubble, List of Bubbles, Page 57, #14.
  11. ^ Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, Volume I, 1852 by Charles Mackay, LL.D. Chapter 2 The South-Sea Bubble, List of Bubbles, Page 53, Paragraph 2.
  12. ^ Chairman’s Letter 2000, Berkshire Hathaway, Page 14, Paragraph 2.

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