You can ask any of my 10-Minute Millionaire subscribers: The most profitable stock setups are the extremes that come when prices get "stretched" like rubber bands. It happens in individual stocks and in entire markets, too, and the gains can be big and fast - triple and even quadruple digits.
Those extremes come, frankly, when market participants (people) act crazy, when they're irrational.
There's a catch: In order to capture those profits effectively, we have to remain completely rational at all times.
In other words, identifying crazy behavior - and avoiding it ourselves - is fundamental to profitable trading.
It can be tough, but it's oh so rewarding...
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When Decision-Making Goes Bad
All other things being equal, most adults are capable of making good, self-interested decisions; no, I won't drive at 100 miles per hour down this busy highway, or, yes, I'll eat a sensible breakfast.
But decision-making for most people radically changes when they are faced with some combination of losing money and uncertain results.
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This potent combination changes people from logical, math-based decision makers to emotional, experience-based decision makers. Using emotionally charged shortcuts or so-called "rule of thumb" guidelines makes us pretty lousy at deciding things.
Traders and investors love making profits... but they hate losses even more; they will go to great lengths - extremes, you might say - to avoid them. Traders rationalize that "it's not a loss until I close out the position." So they hang onto little losing positions and let them turn into big losses. And traders love having a winning trade, so they tend to take them very quickly instead of giving a winning position the time to turn into an even bigger winner.
One of the key principles in my trading research services is that we use these emotional decisions that drive markets to extremes to find great trade entries.
And we avoid falling into emotional traps - or biases - ourselves by first recognizing the biases exist and second by having tools to combat them.
How Rational and Irrational Behavior Impact Investing
Daniel Kahneman, the Noble Prize winner from 2002, identified three distinct decision-making problems. Let's look at the psychology behind these problems and how you can avoid them in your trading.
Adopt an attitude of indifference to losses: Consider losses a business expense. Better yet, frame your losses as the necessary "raw materials" for your business, or as "tuition" for a lesson. Framing losses this way has several clear benefits. You understand that losses are a required part of trading. You want to minimize the cost of raw materials, not avoid them! If you never bought any raw materials, you could never make any products.
Accept uncertainty as a part of trading: The 2002 Nobel Prize winner found that people pay too much to avoid uncertainty. There are many areas in life where people accept uncertainty: Relationships are almost always uncertain; so are fishing trips and cheering for the Detroit Lions. In any of these endeavors, we don't know how they will end. It's the just the same with our trading. Accept that any single trade could be a win or a loss. Get out if you're wrong, and hang on if you're right. Over a large number of trades, good traders and good trading strategies will win. But for any one trade, anything can happen. So don't get emotionally attached to a trade. Execute your plan and move on to the next opportunity.
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Understand the law of small numbers: Traders, like golfers, seem to be eternal optimists. A golfer can take 100 bad swings and still be excited to go out and play tomorrow because of one good shot. In a similar way, traders often draw broad conclusions from a ridiculously small number of data points. I wish I had a dollar for every time I've heard someone say, "That system stinks - it lost three times in a row!" only to then have their optimistic thought process kick in with, "There has to be something better out there!" Realize that it is impossible to draw a meaningful conclusion from a small number of data points. Three, four, or even 10 occurrences are not enough to draw a conclusion in the trading world (or in any complex environment). Spend the time to understand why your trading or investing strategy works, and don't throw it away after a few losses. In terms of statistics, 30 trials is usually the minimum number needed to make any meaningful decision for something as simple as a coin toss. For more complex systems (like the stock market), even more trials are required to draw meaningful conclusions.
As a trader or investor, keep your emotions in check, and understand what mindset biases you're prone to give in to. Let your knowledge of your system guide your decision-making. That'll take you a long way toward solving Nobel-sized problems that plague all sorts of traders - and it'll take your profits to the next level.
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About the Author
D.R. Barton, Jr., Technical Trading Specialist for Money Map Press, is a world-renowned authority on technical trading with 25 years of experience. He spent the first part of his career as a chemical engineer with DuPont. During this time, he researched and developed the trading secrets that led to his first successful research service. Thanks to the wealth he was able to create for himself and his followers, D.R. retired early to pursue his passion for investing and showing fellow investors how to build toward financial freedom.