Good traders make rational decisions. They don’t let their emotions impact their buy, sell, and risk management choices. This is especially important when the market is choppy.
Choppy markets tend to lead investor/trader thinking. Traders tend to become bearish AFTER the market tanks, and traders tend to become bullish AFTER the market surges. This means that these traders are no longer thinking independently or rationally. They are just following the market.
Why you cannot let emotions control your portfolio
Warren Buffett said “be greedy when others are fearful and be fearful when others are greedy”. This is easier said than done because we are all human. No one is perfect. Most traders and investors tend to “be greedy when others are greedy and be fearful when others are fearful”.
Humans are social animals. We cannot live in isolation for long periods of time without going mad. That’s why other peoples’ thoughts impact our own thoughts. Even I get a little greedy when the market goes up and a little fearful when the market goes down. Feeling these crowd-driven emotions is just a part of being human.
But you cannot let these emotions determine your trading decisions.
- The best traders have a clearly defined strategy. Trading is about probability. Simple, cold, hard math. It isn’t about following a hunch or “gut feeling”. Your emotions will control your “gut feeling”.
- Every human has an innate “fight or flight” instinct when faced with danger. And when a danger that you cannot fight such as a market crash comes along, every human’s innate instinct is “flight”. This isn’t logical. If the market is falling a lot but the fundamentals are solid, that isn’t a time to cut losses. That is a time to double down on your position because the market will mean revert soon.
How to control your emotions when trading or investing
This is why I advocate a quantitative trading strategy instead of a discretionary trading strategy. The first advantage is obvious: you can backtest a quantitative strategy to see how well it works but you can’t backtest a discretionary strategy.
The second advantage is also important. Quantitative strategies remove emotion from the picture. You will buy and sell without letting emotions interfere with your trading as long as you stick to your model.
Quantitative traders stick to the buy/sell rules that they created when they were not emotional. Traders tend to be rational when building the model.
How discretionary traders can avoid emotional bias
Discretionary traders can also control their emotions when trading. Just follow a simple checklist. Do the following when you find that the market is leading your train of thought.
- Write down all the bullish and bearish factors and separate them into 2 lists. Order the “Bullish Factors” from most important to least important. Order the “Bearish Factors” from most important to least important.
- Writing down your thoughts will make things more clear. We often fixate around 1 point and can’t let it go when we don’t write things down. We let that 1 bullish/bearish factor seem more important than it really is. When you write down all the bullish and bearish factors, it puts a single factor into perspective.
- Focus on the most important factor for your market. When there are several bullish and bearish factors that conflict with each other, always focus on the 1 factor that is the most important. Every market has 1 factor that’s more important than all the other factors
- For example, the stock market’s most important factor is the economy. So when the fundamental factors are bullish but the technical factors are bearish, focus on the fundamental factors.
Essentially you want to ignore what the price is doing right now and act as if the market’s recent volatility does not exist. Focus on what your trading strategy is saying. Act as if the price doesn’t exist.
Traders tend to let their positions cloud their thinking. For example, traders that are long will want to find reasons for why the market should go up. When the market is extremely volatile and fear/greed creeps in, ask yourself:
If I didn’t have this position today: would I put on the exact same trade as the one I have right now
This means that if you could wipe the slate clean, would you make the exact same trade? Are the reasons that you were initially bullish/bearish still valid?
Here’s one last point to consider. If the market’s recent volatility is turning you into an emotional wreck, then you should decrease your position size. You are trading way too big.