Emotional intelligence
in stock trading

Emotions and markets

Markets are largely subjected to the human factor.


Thus technical literacy and intelligence is not enough for efficient trading

Emotional intelligence, which is as well a control on one's own emotion and
an understanding of other people (i.e market players ) emotions is the
other key for efficiency when facing operations
that entail high risk / high
reward challenges..


Credits.
This text is a portion of the content from
"Improving-emotional-intelligence-of-stock-traders-and-stock-dealers"
a knol in co-authorship with Narayana Rao K.V.S.S. and Sajid Khan
(over 10 k page views before Knol closure).

What is emotional intelligence?

Emotional intelligence is:

as they largely drive our decisions and behaviors
as their behavior affect us and our behavior affect them.
The human factor in trading
and the role of emotions

However important are technical abilities and economic competences for
stock traders and stock dealers,
the person human factor also plays a
crucial part.


Behavioral finance research explored various
behavioral biases shown
by people in their financial decision making.


* Some of these biases are cognitive (because of memory or reasoning
   flaws).

* Some others are reflexive (= caused by reflexes / habits).

* But many are emotional and might express emotional intelligence....
   ..or lack of it.

Emotions can be defined, to make it simple, as painful or pleasant
feelings
(actual or expected pain or pleasure) that activate the brain
.


Neuroscientists, nosy codebreakers who chase your little mind secrets,
explore brain areas, secretions and electric waves which are directly
related to emotions (*), including in trading decision situations (this
is the area of “neurofinance”).

(*) Of course they explore also cognition and reflex connections

Experimental economics also studies how decisions are made among
groups
of traders acting in simulated markets.


While stock traders and dealers who remained in the trade for a long period
have a good knowledge of trading methods, of the history of up and down
market trends and of economic factors, their emotional intelligence may be
short of the high order required for successful trading.

Less or no attention is given to the fact that human beings are emotional
beings and that emotional intelligence is a factor in most trades, especially
as many times stock trades follows a herd mentality.


Behavioral finance research has documented the biases exhibited by
financial professionals.

This article explains the science of developing our emotional intelligence
strategies
in relation to stock trading.

Emotional aspects that traders
should be aware of

See also Beware of your own investing traps!

Positive or negative energy?
Emotions are forms of energy.

Energy can be constructive or destructive.

Whatever the automaticity of some of their behaviors, human beings are
not just cold mechanical beings.

pain pleasure Emotions are usually needed to drive their actions.
A lack of emotion kills the desire to act.


On the other hand too strong emotions, expressing excessive pain or
elation
, can overwhelm rational thinking
and wisdom. Then they affect
perception, representation and decision making.

Neurosciences have brought various findings on that “primacy of
emotions”
in many decisions, and specifically in money-related
decisions.

Therefore emotions can be useful as well as harmful for
traders
.

Also not all behavioral biases are damaging.
Some practices that might go
against our self-interest might relate
to other, quite respectable, needs
or goals.

.=> Traders should "know themselves" and check what emotions
       take part in their decisions and whether they  lead to rational /

      
effective attitudes, choices and behaviors or to behavioral biases
      
with unintended or harmful effects.

Methods to cool down the brain areas and inner chemical secretions that
foster a primacy of emotions
over dispassionate thinking might help.

The emotions that might impact trading
Here are the most common emotional phenomena (some more or less
biased, some neutral, and some others still more or less constructive,
as everything is a matter of degrees) to be aware of:


* Greed / hope / optimism
/ wishful thinking, and even magical
  
thinking and illusion of control.
Positive thinking is a good motivator, but not to the extent of stubbornly
denying
reality

* Fear / aversion / pessimism.

Sometimes (falsely) compensated by inventing “good stories” and
false
beliefs to avoid the pain created by the unknown,
the
fundamental uncertainty of a complex and changing world


* Emotional asymmetry
: the prospect theory shows how players
   ted to  give more mental value to losses than to gain.


* Mental accounts:
different risk attitudes/

changes of risk attitude according for example to the origins of
funds (savings or windfalls).

Also forgetting to take into account transaction
costs, inflation…

* Haste and hyperactivity (noise trading…) – or procrastination.

* Stress control vs. collapse under stress and uncertainty.

* Willpower and discipline …or the lack or them making for erratic or
   counterproductive
behavior.

* Getting carried away from one’s goals by uncontrolled emotions.

* Independence – Mixed or not with empathy, as human beings
   need  social ties.

* Affect heuristic (personalization):

they give preminence to pleasant or unpleasant feeling, a liking or
a dislike towards a person,
an organization or its products more
than via an objective analysis.
Madoff’s clients liked him!

* Mimicry, obedience, peer pressure, herd mentality, consensus, here
   also linked to the vital human need for togetherness and social
   ties,
but sometimes in a perverted way.

Also
* excessive trust in analysts, experts and medias.
* “foot in the door” (emotional commitment to previous decisions,
* endowment as the feeling that what is owned has more value
   than what the market offers).

* Overconfidence / pride / narcissism / hubris / illusion of competence
   or knowledge.


* Envy, a negative feeling towards colleagues which successes are judged
   undeserved.

   Such rivalry can lead to disastrous risk taking.

* Underconfidence
* Neither over- / under- confidence:

   => selflessness / objective wisdom.

* Clear or fuzzy motives?
* What
preferences (are they transitive?), goals, needs, motivations?
 

Do actions have a good chance to meet the goals (a practical
definition of
rationality) ?
And are those goals themselves “rational” (here in the sense of as f
far as possible non damaging)?

Is for example status / trophy seeking erasing a sense of rational
self-interest?


* Anchoring to previous reference price, situation or paradigm.
 

Here we enter into selection biases, focusing on an element and
neglecting others, because of cognitive limitations
but often also
as it would be emotionally unpleasant to consider other possibilities
(cognitive dissonance).

* Framing as a partial representation of the situation or issue,

here also a selection bias.

In those two cases -anchoring and framing – (biased) emotions
are active, but
(biased) cognition and simplified heuristic (mental
shortcuts and mental habits) play
also a part.

* Autopilot behavior (habits, reflexes, even addictions).
Although here, emotion as well as cognition are both bypassed by
automatic
“near-physical" reactions to stimuli.

Effects of collective emotions
on financial markets

Another thing traders should detect and take into accounts, are
group collective emotions that might distort or at least influence
the
general market behaviors and performances(prices, returns,
volatility).


Also they must be conscious that, attitudes might differ or converge
between the main categories of players.

Here are some of the effects to be aware of:

* Market mood / sentiment (collective optimism / pessimism), herd
   instinct.

* Mistaken collective reactions to events and to information.

* Also underreaction – overreaction by the bulk of market players.

* Trends, cycles, bubbles, crashes , as a result of this underreaction –
overreaction
collective process

* Collective overconfidence that brings a neglect – and impreparation
  
for -“rare events” that might destabilize the whole system, for example
   by
leading to a systemic liquidity crisis.

* Price and return anomalies / inefficiencies (market distortions that
   contradict the “Efficient Market Hypothesis”)

* Industry rotation (either short term as market fads and fashions, or
   long term as industry life cycles)

* Some manipulations by purported experts playing the greed or fear
   game.

* Stock value perception, stock image

And so on…

A two step method / counter-measure inspired by behavioral finance
research, that investors can use comprises


1. debiasing (correcting the emotional components of market
    prices / returns / trends)

2. and rebiasing (trying to project how those components will
     evolve in the future).

The “trick” can be used in stock markets at the stock valuation level
(using for example the stock image coefficient)
or, at the trend spotting
level, when looking at misreactions (under-reaction / overreaction notably).

Back to collection : Finance articles migrated from Knols

 
M.a.j. / updated :02 Aug.  2015
All my ex-knols / Tous mes ex knols 
Disclaimer / Avertissement légal

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