Six psychological principles that can help you improve your trading

If you want to improve your trading results, the first step is understanding and applying some basic psychological principles. We’ll look at six of the most important ones. By keeping these in mind, you can put yourself in a better position to succeed in the markets. 

The sunk cost fallacy 

It is one of the most common mistakes that investors make. It occurs when we continue investing in something (or hold onto a losing trade) simply because we’ve already invested so much time or money. We tell ourselves that it would be a waste to give up now, after all, we’ve been through. 

The reality is that sunk costs are irrelevant. What matters is the expected return from investing further in the project, not how much has been invested in the past. If continuing to invest will likely result in a loss, it’s best to cut your losses and move on. 

Anchoring and adjustment 

‘Anchor and adjust’ refers to our tendency to place too much importance on the first piece of information we receive (the ‘anchor’) and then adjust slightly from there. For example, suppose you’re shown a list of prices for an item and asked to estimate its value. In that case, the first price you see will significantly impact your final estimate, even if it’s utterly unrelated to the actual value. 

This bias can lead us to overpay for something or hold onto a losing investment for too long simply because we’re anchored to the original purchase price. It’s essential to be aware of these biases to make more objective decisions about when to buy or sell an investment. 

Mental accounting 

It is the tendency to categorise our money in different mental accounts and treat it differently based on those categories. For example, we might view money in our savings account as ‘off-limits’ for spending, while money in our checking account is seen as ‘disposable’. 

It can lead to sub-optimal decision-making, such as not investing because we’re afraid to use our savings. It’s important to remember that all money is fungible – you can use it for any purpose. So long as you plan to replenish any funds you use, there’s no reason to keep your money siloed in different accounts. 

Overconfidence bias 

Is the tendency to be overconfident in our abilities, especially when it comes to forecasting future events. Studies have shown that people tend to overestimate their ability level and the accuracy of their predictions. 

It can lead to taking on too much risk or holding onto a losing position for too long in the hope that it will eventually turn around. It’s essential always to be aware of your limitations and to take an objective view of your investment decisions. 

Availability heuristic 

It is the tendency to base our judgments on readily available information, even if it’s not necessarily representative. For example, we might be more afraid of flying than driving, even though the latter is more dangerous. 

This bias can lead us to make sub-optimal decisions, such as selling an investment simply because it’s been in the news recently (regardless of the underlying fundamentals). It’s essential always to research and not let recent events influence your investment decisions too much. 

Representation bias 

Is the tendency to extrapolate from small sample size and assume that it’s representative of the broader population. For example, we might think that a stock that has performed well recently will continue to do so in the future. 

This bias can lead us to make bad investment decisions, such as buying a stock simply because it’s gone up in price recently. It’s important to always look at the bigger picture and not let recent events cloud your judgement. 

Bottom line 

By understanding and avoiding these common psychological traps, you can put yourself in a better position to achieve success in the markets. Just remember to stay objective and do your research. 

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