As Tim and I have written about before, emotions can be a huge road block in becoming a successful trader. “Trading Psychology” is something you must continuously work on in order to improve your success rate. It is very easy to start buying when everyone else does or selling when everyone else does, known as the crowd mentality, but often people make those bets too late. You here about this a lot right now since the major equity indices like the Dow and the S&P are up around 30 percent on the year, which is a phenomenal return when compared to other years. People can taint each other with their behavior and cost everyone a substantial amount of money. This is sometimes called “market contagion.”
I found an article on Investopedia recently and wanted to repost much of its context here.
Contagion often leads to people making irrational decisions and prevents them from making proper evaluations of the investment opportunities that they comes across. As I stated above, people begin doing things like buying into overvalued stocks or selling at the very bottom. Remember, you want to buy low and sell high, essentially the exact opposite. There are arguments to be made for being the contrarian, but think about where you would be if you had made that move this past year? You’d be out a lot of money.
So let’s look at how exactly contagion impacts your brain when investing. Here is the life example that the article on Investopedia gives:
“Let’s assume that Ivan leads a placid life, earning a good living and putting his money into a secure retirement fund that does ok, but does not ‘shoot out the lights.’ Some of his friends are investing money in foreign bonds, and making double the return that Ivan receives from his conservative fund. Ivan’s resistance is strong at this point, and he follows his gut feeling that these bonds are too risky.
However, out of a mixture of curiosity and envy, Ivan the investor starts asking his friends how well the bonds are doing. They tell him that the returns are excellent, and are sure to stay that way. Ivan’s resistance slowly weakens, as he hears repeatedly how much he is losing out on and eventually, he gives in, buying bonds when they are nearing their peak.
Soon afterwards, some crisis occurs overseas, and his friends start to panic – as do many other investors. Once again, Ivan is contaminated and thinks he should also sell out before it is too late. After all, that is what his friends are doing.
Two months later, when the price is half of what it was when Ivan bought in, he is disillusioned and still recovering from his losses. Under normal circumstances, this would be the ideal time to make an initial investment, to get back in to the market or to top up existing holdings, but the emotions of contagion always work in the wrong direction, and Ivan retreats to recover.”
Harsh reality at its truest form. Stories like Ivan’s happen every day. These emotions are automatic and sometimes we don’t even realize that they are taking hold. It causes investors to forget about conventional wisdom and no longer use caution as they should. When people see what they are missing out on, they immediately want to give in and take part in whatever that is. The same happens when their friends start to get scared, as Ivan’s did. When you see a stock up 60% for the year, you obviously want to think it’s a great stock and that you should get in, but it may be overvalued at that play and begin taking a turn for the opposite direction.
Fear is one of the most powerful emotions. Thus, downward pressure Is more powerful than upward. Negative events, whether macro or micro, will generally bring out strong and faster responses from traders than a positive event would. So, when markets take a turn for the worse, the contagion of panic is far worse than the pressure people feel to buy when there are positive events.
The article goes on to note that there are some positives that comes from contagion. People tend to imitate those that are successful, meaning they will work harder and strive to better themselves in order to have that same level of success. This natural emotional process thus has it’s pros and cons much like most things in life. Just note that it seems to do more harm than good when it comes to investing.
In order to fight this, you have to try to be “emotionally neutral.” make your investments with rationality and a thorough thought process. Do not buy XYZ because your friend did a week ago and is now up 20%. Fear, excitement, and other similar emotions are your enemies when it comes to putting your money to work. Make sure you try looking at both sides of the story. What are the reasons to buy this stock, what are the reasons not to buy this stock. What price seems to be a fair value when compared to its peers, what are some of the macro and micro level risks that could make this stock fall and what are some of the positive events that could make the stock rally?