Beware behavioural mistakes that lose traders money

Effective trading should be a straightforward case of identifying assets likely to go up. If only it were that easy. Even the most experienced traders must wrestle with their instincts to prevent rookie mistakes that can lose them money. Here are the most common:

Over-confidence

Golfer Gary Player was fond of saying ‘The harder I practice, the luckier I get’. This also has a resonance for aspiring traders. ‘Luck’ in trading doesn’t tend to come because you have the magic touch, but because you’re doing your homework behind the scenes. Having belief in your judgement is one thing, but confidence in the positions you’ve taken should come from a rational assessment of their prospects.

Over-confidence can also translate into an unwillingness to admit errors. Too often traders conclude that it would have been the right decision had it not been for that pesky trade war/coronavirus/profits warning. Search your soul and learn from your mistakes, rather than clinging to information that justifies a bad decision. No-one has a magic touch!

Not setting rules

Sometimes you will get it wrong. Even Warren Buffet admits to errors. The key is to ensure that those mistakes don’t end up undoing all the good trades you’ve made elsewhere. Setting parameters around your investments can guard against disasters.

These rules can take many forms. For example, it may mean putting a stop loss mechanism in place when a stock reaches a certain price - perhaps 20% below your purchase price. Consider how much you can reasonably afford to lose.

Putting this type of mechanism in place can guard against traders’ inclination to hang onto losing positions in the hope that they’ll come good. Traders generally struggle to admit their losses, remaining convinced that they’ve made the right decision even when all the evidence points against it.

It is worth thinking honestly and critically about whether your original reasons for entering the position still hold or whether the market is truly undervaluing the stock and its price will rebound.

Confirmation bias

For apparently rational creatures, humans can be highly selective in their use of facts. We favour information that validates our existing view, rather than shaping our view to fit the information. We may even seek out information that confirms our beliefs, making us bolder and more certain in our assumptions. We will also tend to selectively ignore information that runs counter to our view.

Be wary of confirmation bias. Ensure that you are looking at the information objectively and including information that might run counter to your current beliefs. Only then can you build an objective picture on your positions.

Taking short cuts

It is easy to take mental short-cuts. From Enron to Parmalat, history is littered with examples of companies that investors considered untouchable that subsequently failed. This runs across other asset classes: the Dollar may not always be the world’s reserve currency, gold is not always a safe haven, oil companies don’t always pay high dividends.

There is a temptation to think that a trade can’t fail because a company is big or has always been successful in the past. This way of thinking can ‘anchor’ investors to the previous share price. A company may look cheap relative to its history, but that may be because its business is in structural decline.

GDP data

GDP measures the total economic output of a country, taking into account consumer and investment spending, international trade and government spending. If it is growing, the economy is considered to be strong, and the value of the currency is likely to rise, and vice versa.

Ignoring a crowded trade

If everyone else knows about a ‘hot new thing’, the chances are that you’re probably not going to make a lot of money. This was seen clearly in 2019 among the technology ‘unicorns’ coming to market. In spite of their disruptive ideas, companies such as Uber, Lyft, Pinterest haven’t made a lot of money for shareholders since their Initial Public Offering. Certainly, they were disruptive, but everyone knew about it, so they came to market at too high a price.

Understanding and managing your instinctive behavioural biases will help you become a more successful trader. Your instincts can thwart the best-laid research. Don’t let them get the better of you.

If you’re looking to learn more about trading, Fineco offers regular free webinars to help you explore the markets and improve your trading skills with the help of experts.