The aim of investing is primarily to make money and limit unnecessary losses as far as possible. After all, he who makes a loss of 10% then needs to make 11.11% profit to reach break-even. The greater the loss, the more difficult it becomes to reverse that loss. A 25% loss requires a 30% profit to regain one’s original position. A loss of 50% is only offset by a 100% profit. Money management is a key weapon in this regard. That which is not lost, need not be recovered. Unfortunately, if the truth be told, investors are often tempted to throw this wisdom overboard. The emotions of fear and greed form a noxious cocktail that has the power to corrupt the clear sense of even the most hardened investors. Often resulting in the lessons on damage limitation being thrown to the wind, ‘because this time it’s different.’ The famous last words of many an investor just before he topples over the edge of the abyss.
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The psychology of trading
The three main emotions involved in taking investment decisions are greed, fear and regret. Though greed appears to be a ‘wrong’ emotion, it actually isn’t. In the film ‘Wall Street’ the character of Gordon Gekko uttered the now famous statement ‘Greed is good, greed works!’ As a motivation, there is nothing wrong with greed. If this wasn’t true, I guess we might still be walking around in bearskins clubbing our next meal to death. However, as with so many things, too much is unhealthy – even on stock markets. And this quickly leads to overconfidence and addiction. Another emotion that troubles investors is that of fear, basically a healthy emotion. It protects us from entering situations of which we have no experience and in which we are likely to lose control. Too much fear, however, leads to indecisiveness and doubt, which are fatal to investors. The same applies to the emotion of regret. Investors can also become paralysed if they continue to lament a bad decision long after the event. But excessive self-confidence and overestimation of one’s powers is also dangerous. After a winning trade, investors tend to start making bigger and riskier investments. From stocks to options, and from options to futures. This phenomena is especially visible in a bull market in which prices seem to be heading in just one direction. A related problem is that it is very difficult to detect when you are overestimating your own abilities. Nobody has much trouble observing when others esteem their own abilities too highly – just think of those who sing off-key in talent contests. However, investors who overestimate their powers will always get caught out. Losses incurred in this way often wipe out any previous profits in one fell swoop. However, one of the most dangerous consequences of all this emotion is that it makes investors unsure of themselves. An investor paralysed by uncertainty no longer dares to trade. And such paralyses is even more dangerous when, like a rabbit in the headlights, the investor just sits there watching his losses grow without taking action.
Herd mentality
Humans are social creatures who exhibit a herd mentality, and investors are no exception. If certain institutions or investors start to buy particular stocks, other investors follow en masse. Stock exchanges are the perfect place to study the herd mentality. If the analysts of major securities firms – such as Goldman Sachs and Morgan Stanley – issue certain buy advice, there are very few who dare oppose them. And it is often profitable to invest along with the rest of the herd. Remember the saying ‘the trend is your friend’. However, the trick is to recognize on time when the signals suggest that the herd is about to reverse direction. Once bulls turn to bears, prices can suddenly plummet very fast.
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