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
This text is a portion of the content from
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:
- Understanding / mastering one’s own emotions,
the emotions of others,
- Using those understanding for the benefit of all.
and the role of emotions
However important are technical abilities and economic competences for
stock traders and stock dealers, the human factor also plays a
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
* 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
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.
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
Therefore emotions can be useful as well as harmful for
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.
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
* Fear / aversion / pessimism.
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/
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
* Getting carried away from one’s goals by uncontrolled emotions.
* Independence – Mixed or not with
empathy, as human beings
need social ties.
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.
* 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
* Envy, a negative feeling towards colleagues which successes are judged
Such rivalry can lead to disastrous risk taking.
* Neither over- / under- confidence:
=> selflessness / objective wisdom.* Clear or fuzzy motives?
* What preferences (are they transitive?), goals, needs, motivations?
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
* Anchoring to previous reference price, situation or paradigm.
neglecting others, because of cognitive limitations but often also
as it would be emotionally unpleasant to consider other possibilities
* Framing as a partial representation of the
situation or issue,
here also a selection bias.
are active, but (biased) cognition and simplified heuristic (mental
shortcuts and mental habits) play also a part.
* Autopilot behavior (habits, reflexes, even addictions).
automatic “near-physical" reactions to stimuli.
on financial markets
collective emotions that might distort or at least influence
the general market behaviors and performances(prices, returns,
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
* 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
And so on…A two step method / counter-measure inspired by behavioral finance
research, that investors can use comprises
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).
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