Strength - The hidden but most important tool

Psychology

You need to be aware of your emotions all the time and attempt to cast them out and be cold and hard. If you learn how to do this, then let me know! In psychology, the illusion of control refers to people's belief that they have influence over the outcome of uncontrollable events. People will often let a position run rather than cutting for a loss in the belief that they know more than the market. Typically, once a position has been stated, most find if very hard to move away from it. When movement does occur is does so only very slowly and usually in a financially painful manner. Psychologists call this effect conservatism bias. Remember, never fall in love with a position; because it will never love you back.

Quite a few years back I read an excellent book called 'Influence' written by Robert Cialdini. It was the sort of book I had been searching for, for years. This confirmed that the human world tends to anchor itself to a framework significantly influenced by things other than logic. Having recently re-read 'Against the gods" by Peter Bernstein, which also delves into these murky depths; you learn that while markets are generally considered to be efficient they can also be totally irrational.

This field of study has attracted a lot of attention in recent years and this branch of psychology is called behavioural finance. Behavioural finance looks at historical phenomena that contradict the efficient market hypothesis. It argues that people are not nearly as rational as traditional theory makes out and that psychology, not rationale, often drives a market and in both directions. Researchers have regularly reproduced market behaviour using very simple experiments.

Losses versus gains

Offer someone a choice of £50 or, on the flip of a coin, the possibility of winning £100 or nothing. The chances are that the person will go for the sure thing. Offer a choice of a sure loss of £50 or, on a flip of a coin, a loss of £100 or nothing. The person will probably take the coin toss. In absolute expectancy terms the scenarios offered are exactly the same. There is no benefit to choose one over the other in the long term; yet people tend to go for the coin toss to save them from loss. People tend to view the possibility of recouping a loss as more important than the possibility of greater gain.

Social proof

Social proof highlights why people tend to imitate others. When a market is moving up or down, people are subject to a fear that others know more or have more information. As a consequence, people feel a strong impulse to do what others are doing using outside views (the market) as a reference point. I regularly see this repeated in a number of markets. People see a trend developing and rush into join that trend but only succeed in forcing the price away from true value before arbitrageurs nip in to take advantage of that deviation. People panic, close out their positions and the normal trend resumes.

Fear of regret

Make an error and you will feel an emotional reaction. Gamblers who make errors on betting markets have a tendency to chase their losses. Often they will get away with it but they only stop when they chase one too many losses and face a catastrophic drawdown. Faced with the prospect of selling, traders become emotionally affected by the price at which they took a position. They tend to avoid closing out the position as a way to avoid the regret of having made a bad decision. This is rarely a good move especially in the long term. This is why stop losses have been created!

Over Reaction

People get optimistic when the when doing well become pessimistic during downturns. This appears to be because people place too much importance on recent events. People have a tendency to extrapolate recent trends way off into the future when in reality, that is rarely going to be the case.

The topics I have touched on here are just a few of the topics covered in Behavioural finance. Hopefully that have given you a clue as to how you should approach a market. I have practiced and got better and better over time and have a cold heart, I believe, gives me an additional edge in the market. Edges come in all shapes and sizes.