EMOTIONS: THE ENEMY WITHIN
As logical and rational as we try to be, there is no denying it: our decisions are made based on a combination of reason, intuition, and feeling, each in degrees depending on our personal makeup and the specific situation. Once again, this is a mode of decision making that has great utility in many situations, but it can misfire in the context of trading and markets.
Emotions can create stress that unbalances the brain on a chemical level. Emotions can cause us to overweight and underweight certain factors, and sometimes to make decisions without any reasoning at all. Successful traders have many strategies for dealing with their emotions, but that is the common thread—they have all found a way to integrate their emotions into their trading process. Some deny and control them with iron discipline and try to become logical machines, some seek modes of trading that remove emotion from the decision process, and some embrace their emotionality and actually build their trading process around it; but in all cases, they understand their emotional balance and how to control it within the framework of their work flow.
Ego
We all have egos. (I am using the term ego here in the colloquial sense to mean selfimage rather than in any formal, psychoanalytical context.) Everyone likes to be right, likes to be seen as intelligent, and likes to be a winner. We all hate to lose, and we hate to be wrong; traders, as a group, tend to be more competitive than the average person. These personality traits are part of what allows a trader to face the market every day—a person without exceptional self-confidence would not be able to operate in the market environment. Like so many things, ego is both a strength and a weakness for traders. When it goes awry, things go badly wrong. Excessive ego can lead traders to the point where they are fighting the market, or where they hold a position at a significant loss because they are convinced the market is wrong. It is not possible to make consistent money fighting the market, so ego must be subjugated to the realities of the marketplace.
One of the big problems is that, for most traders, the need to be right is at least as strong as the drive to make money—many traders find that the pain of being wrong is greater than the pain of losing money. You often have minutes or seconds to evaluate a market and make a snap decision. You know you are making a decision without all the important information, so it would be logical if it were easy to let go of that decision once it was made. For nearly all traders, this is not the case because we become invested in the outcome once risk is involved. Avoiding emotional attachment to trading decisions is a key skill of competent trading, and being able to immediately and unemotionally exit a losing trade is a hallmark of a master trader.
Being wrong is an inescapable part of trading, and, until you reconcile this fact with your innate need to be right, your success will be limited. Earlier in this book, I suggested that an appropriate way to look at normal trading losses is not as losses at all, but simply as a planned, recurring cost of doing business. Though many traders feel shame, anger, and hurt over losing trades, this is illogical—the market is so random that it is absolutely impossible to trade without losing. Many good traders are wrong far more often than they are right; trading is not about being right or predicting the future. All you can do is to identify places where you might have a small edge in the market, put on the trade, and open yourself to the possible outcomes.
Hope and Fear Scylla and Charybdis were two sea monsters in Greek mythology situated in a narrow strait so that ships had to pass close to one or the other; captains had to choose because it was not possible for a ship to make the passage and to avoid both. For traders, fear and hope are the twin monsters, and no matter how experienced we may be as traders, we are unable to completely conquer them. What we can and must do, however, is to become aware of our weaknesses and our responses to these emotions. If we can monitor ourselves for susceptibility to errors, we can often intervene before the emotional reaction has resulted in a poor decision.
The reasons for fear are obvious. Most traders are afraid of loss, though this is probably rooted in a misunderstanding. It is wrong to be concerned about or to focus on the normal losses that accrue as part of the trading process, but there is certainly the danger of the unexpected and uncontrollable loss from an outlier event. Recent flash crashes have shown that stable markets can have unprecedented sell-offs; who would have thought that a big blue-chip stock could drop 80 percent in a few minutes? Many traders also face deeper, darker fears that are tied in to questions of self-worth, security, and personal finance. Even for a well-balanced person, trading can be a serious emotional challenge at times.
As powerful as fear is, many traders find that hope is actually more dangerous. Hope encourages us to take potentially reckless risks that we might not otherwise take. It can keep us in winning trades long after the profit potential is gone; many traders give back a lot of open profit because they are clawing for even more. Many traders are also loath to exit their losing trades, sometimes even at their predetermined stop level, because they are hoping that the trade will turn around and become a smaller loss. Once again, one of the distinguishing characteristics of successful traders is an ability to cut losers with minimal emotional attachment. No individual trader can succeed without mastering both hope and fear.
After many years and many mistakes fighting these twin monsters, I found a solution that works for me. It is deceptively simple, but it is difficult to do consistently. Here it is: for every trade you put on, immediately assume you are wrong. This is your baseline assumption, and, if you find evidence to the contrary (that you are right), be pleasantly surprised. This works because it takes all pressure off you and all hope out of the trade. Normally, once you have made a decision to buy a market, confirmation bias kicks in and you will start to subtly overweight information that supports your position. Instead, think, “I bought it thinking it will go up, but I’m probably wrong.” There is no struggle, no fight against the reality of the market, and also no fear because you are expecting to be wrong. This is a subtle shift in your thinking, but it can produce a powerful change in your perspective and your behavior.