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Trading Psychology (Part 2)

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Your success or failure in trading depends on your emotions. Having a good trading system is not enough. You may have an exellent system, but if you feel upset, anger, arrogant, your account is sure to suffer. According to conventional financial theory, participants are, for the most part, rational wealth maximizers. However, there are many examples where emotion and psychology influence our financial decisions, causing us to behave in irrational ways. Behavioral fianance is a new field that combines behavioral and cognitive psychological theory with conventional economics to provide explanations for why people make irrational financial decisions. This topic will give you an edge to understand the underlying reasons and bias that cause people behave against their best interests. Hence, you may have some useful tips applying to your trading style.

Confirmation Bias


This tendency means that an investor would be more likely to look for information that supports his idea . His brain filters selective information and pay more attention to data that supports his opinion while ignoring the rest. As a result, this bias gives to him an incomplete picture, a narrow view because of one-sided information. Then he becomes overconfident and loves his position too much even though market starts moving against him. Then he removes his stoploss because he believes in his idea. But the market is always right and it is not aware of his opinion. Hence, his account will suffer a big loss. To avoid confirmation bias, you need to see an complete picture, study all good and bad news related to your investment. And never forget set your stoploss order. It will protect you from disaster when your original idea is wrong.

Overconfidence


People tend to have unjustified confidence in their abilities and decisions. They overestimate or inflate one's ability . For instance, people often inflate their abilities in stock picking, which can beat the market. But keep in mind that professional fund managers still struggle at achieving market beating result. Overconfidence causes a trader overtrade. He buys/ sells often that leads to a negative effect on his return. In addition, he credits for himseilf when he is right. But when he is wrong, he thinks that it is a bad luck. To avoid overconfidence, you should be humble to realize your true ability. And of course, always use stoploss order when everything goes wrong. Do not waste your time to prove markets you are right.