Trading Psychology 101: The Most Dangerous Trade

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one,” noted Charles Mackay in Extraordinary Popular Delusions and the Madness of Crowds.

Granted, that was written in 1841.

But what he had to say is still relevant to the way traders behave today.

Many traders tend to do what every one else is doing. 

If the herd is buying Apple (AAPL) all of a sudden, we want to jump in, too.  The idea is that the herd must know something we don't.  Many are just blindly buying Apple because Berkshire Hathaway is, or because of excitement over the new iPhone.  Unfortunately, not many of them are even aware of how technically overvalued the stock has become.

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Or, if all of a sudden, your favorite stock is falling out of the sky, you immediately sell because every one else is, too.

Unfortunately, we never stop to think or do the research necessary.

However, in most instances, acting against the flow, moving against the herd, taking the path less traveled is the better way to trade.  Once you consider the herd gets it wrong far more times than it gets it right, the path less traveled becomes the more profitable route.

At some point we all conform to a degree with the clothes we wear, the way we speak, the way we act in situations.  But when it comes to making money, conformity typically leads to loss.  On Wall Street, many conform for social approval, to feel like they’re part of the “in” crowd that knows what’s coming next.  Traders will mimic actions of a larger group so they don't feel left out of a trend, or miss what the herd believes is a “can’t lose” trade.

In many cases, members of the herd can’t help themselves, and actually do themselves a great deal of disservice by doing so.

In fact, according to a 2009 Kiplinger article titled, “Don’t Trust the Crowd”:

What's scary about the herd mentality is how insidiously it gets you to see things differently. In fact, a recent experiment showed that we might actually be hard-wired to believe what the crowd tells us. In the experiment, conducted at Emory University, participants were asked to look at an object (an assemblage of cubes) and then judge how it would look if it were rotated slightly.

But there was a twist: Other participants--who in reality were actors hired for the experiment--were instructed to give wrong answers in an attempt to sway the opinions of their fellow participants.

Sure enough, the real subjects, influenced by the actors, gave incorrect responses, despite what their own eyes told them.  Brain scans found that participants didn't just decide to go along with the crowd. Instead, the crowd's opinion actually changed their perception of the problem. Participants "saw" the objects differently. The herd, it seems, alters our perception of reality.

What allows a Wall Street participant to think outside of the herd is the awareness of just how easily we are influenced, as also highlighted by that article.  “Then you can concentrate on the smartest investing strategy: spreading your risk across many types of investments and periodically redistributing your money among them.”

So how do we break free of the herd?

We have to understand there are four psychological states of emotion that drive our stock buying decisions in all markets, including greed, fear, hope and regret.  Unfortunately, groupthink can greatly impact all four.  If the group is greedy, individuals tend to be greedy.

However, an individual awareness and understanding of these emotions, as developed by the herd can help.  It simply involves removing your emotion from the trade and not allowing yourself to get caught up in the psychology of the herd.  This can be accomplished with stop losses and trailing stop losses for example, so you’re not rushed out of a trade just because every one else is selling.

Other ways to break free of herd mentality include:

  • Knowing what to expect – Know that losses are a part of the business of trading.  There will be some days when your trades exceed your expectations.  However, there will also be days when your results are far worse than you hoped.  One way to tackle this is by being aware of your personal risk tolerance, and by setting a set percentage amount per trade.  It’s called trading with a plan.
  • Develop and stick with your own personalized system of trading.  Successful traders have a system. They stick to it religiously, even if it seems like it doesn’t always work. You must remain consistent in how you trade and when you trade.
  • Know when to trade.  Far too many traders will trade on excitement or extreme fear simply because every one else is.  Don’t allow yourself to get caught up in that trade.  Allow the trade to settle.  Check to see what the news was.  Look at the trade technically and fundamentally to see what’s really happening.

If you can integrate these insights into the way you approach a trade, you’ll gain a significant advantage in the marketplace.  Best of all, you won’t react just because the herd is.  Having the right mindset is the key to investing success.  Without it, you may as well flush your cash.

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Learn to Trade From Seasoned Professionals. Apply Your Knowledge
and Skills and Get Paid To Trade! Learn How Here

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