Emotions are very hard to keep in check when trading investments including stocks, commodities, and real estate. It takes most professional investors years of investment experience before they learn to trade using a system vice using purely emotions. Taking the emotional element out allows the trader to use repetition of entry and exit point criteria for more consistency in results. Trading on emotions, as most amateur investors do, usually provides no consistency of entry and exit points resulting most of the time in more losses than wins over time. This article will explore how many pros count on these emotional traders when making buy and sell decisions. I’ll be using examples that focus on stock investing, but you could just as well have this article talk about investing in anything.
Greed and fear are part of our culture:
Think about when you were a kid. When you saw your friend with a newer bike or neater toy, you wanted one too. That was greed and envy at work – wanting more than you have. Also think about when you had something really nice like a new cool bike that you knew others wanted. Most likely you had a chain to lock the bike up when parked. When at home, you kept it in the house or garage. That was fear at work – the fear of loss. All our lives, we have been conditioned by advertisement and other influences to want more than we have and to fear losing what we do have. When trading investments, these emotions usually work against you, but do play right into the hands of professional traders.
Greed and fear work against trading investments:
When looking for stocks to invest in, amateurs will many times look at stocks that are rising fast and think the stock has to continue going up. Greed kicks in and they buy into the stock when the price has already risen significantly thinking something along the lines of “the price doubled in the past week so I just need to get in to double my money and then I’ll get out”. You know the rest of the story. Right after buying the stock, the price drops quickly. At this point, fear kicks in. The investor may feel he or she needs to keep holding onto the stock until it comes back to the purchase price to get out at break even. Some of these investors will let greed kick in again and buy more shares of the stock at the lower price. As the stock continues to drop, the investor gets more nervous. Many of these investors are 100% invested, meaning they put all of their money into stocks (or whatever they are investing in) at all time. Therefore, when the price drops even further, they begin to panic. Many times the stock eventually drops so far that these fearful investors give up hope in the stock and sell in a panic to prevent further loss.
What happens next? Again, I bet you know – the stock rises quickly. Now the investor is in a quandary. They lost so much money on the stock that their greed kicks in to make up the loss buy buying back into the stock “just long enough to get back to break even”. Some times this works, but many times it does not as the stock again may take another dramatic fall in price even further than when the investor bought in the second time. Again the investor eventually panic sells at another large loss. This cycle may repeat itself several times or even with other stocks as the investor looks for another fast rising stock to get in and make up the loss from the first stock with.
Doing this over time almost always ends up with the investor losing all of his or her available investment funds unless they are lucky enough to have a wife that eventually says “you will stop now! No more!”!!! Thank God for conservative wives to save us for utter ruin!!! Ha! Sorry, just had to get a little of my own past experiences during my amateur trading years into this article!
Pros count on the panic both ways – buying and selling:
If you watch these “high flying” stocks for a while, you will see they trade in wide price ranges. Also, you will notice that the volume of trades is usually highest at the point when the price changes direction (either up or down) from the direction it was going previously. Those high volume price change days are key trading days of greed (must buy since it is surely going higher) and panic (must sell to cut my losses). On those days, the pros are doing the opposite of what the amateurs are doing. When the price does dramatic drops that force the amateurs to panic sell, the pros are buying which usually drives the price back up again. As it rises, the pros are selling all along to get out before the amateurs buy in bulk. When the price gets high enough, the pros start selling in much large numbers that overwhelm whatever purchases the amateurs are doing. Therefore, the price start dropping. The amateurs panic as the price drops and sell all the way down.
Another tactic used by many pro traders is to short sell the stock when prices are high to drive it down (see a previous article where I cover short selling in detail). When the price gets low enough, these short sellers must buy back the stock. Therefore they are motivated to cause those high volume dramatic drop in price days when amateurs panic and sell out their shares. The short sellers are able to find stocks to buy back at these low panic prices to close out their short position. It is important that you understand this is only one of many tactics used by professional traders to help influence the price of stocks that works against emotional traders.
Professional traders use a system to determine buy and sell points:
Their system may include emotions as a guide, but most use data, facts, trends, trading patters, and other measurable information to trigger buy and sell points for investments. Personally, I like to first look at stochastic trends and the MACD to look for these key days of panic selling and greed buying to determine when I will either get in or out of a stock. I’ll also look at many other data to confirm my initial look at the stock. All of this information goes into my particular trading system to let me know when I should buy or sell a stock (or whatever investment I’m using a system on). Most professionals are also using a system that tells them when to buy or sell a stock. It is important to understand as an amateur that you are entering a market where there are many professionals that are also buying and selling using a system. It is important for you to educate yourself on all of the available decision supporting data to come up with a system of your own that works for you. Don’t forget to consider systems that make you money when the stock goes down, not just when it goes up. Making money both when the stock goes down and when it goes up will help your long term success as a trader.
Consistency of trading rules gives the best probability of success:
Consistently applying your system over time by taking out the emotions will give you the best long term success in most markets. However, in todays extremely volatile market where prices can change by very large percentages on a daily basis, it is very hard to apply a consistent system. It may make the most sense in those situations to wait out the market until it stabilizes before starting up your system again. This is so hard for many people since they get greedy and feel they must enter the market at the lowest price to get the largest potential gain when the market recovers on an upward trend again. Continually trying to buy into the lowest price in todays market conditions has repeatedly shown that we have not yet reached the low price. You end up getting in at a high price and getting out at another low price, repeating your larger and larger losses long the way. It is then tempting to continue trying for fear of not being able to make up those losses if you miss out on getting into a recovering market too late after prices have already increased. That is why the consistent use of a system without emotions in normal market conditions is so important to prevent rash buy and sell decisions.
So much more to learn:
This article was only meant to be a very top level overview of how psychology plays in the trading of investments. I will cover various specifics in future articles that I hope continue educating you on being a successful investor based on my own experiences and hard lessons. I certainly don’t claim to have reached the completely unemotional state, far from it. After all I am human, but always learning and applying those lessons in continually improving my system as markets change.
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Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at MarcobeInvestmentsInc@gmail.com with any questions, thoughts, or requests for other topics to cover in future articles.
This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html. This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision.