2. Notes of a Stock Psychologist: The Myth of the Rational Investor
Whether we like it or not, human psychology interferes in the vicissitudes of financial markets, in their ups, downs and periods of calm. As a practicing psychologist, I have not been asked for a long time – what are you doing on the stock market? I not only trade myself, but I am also a specialist in teaching methods of competent application of exchange opportunities to private savings.
In 2002, the Nobel Prize in Economics was awarded not to an economist, but to a psychologist – Daniel Kahneman. He studied the psychology of human forecasting, the specifics of economic and financial decision-making under conditions of risk and uncertainty. In the course of simple and witty experiments of his group it was shown nothing but human inadequacy of perception and behavior: in a situation of choice people most often neglect common sense, and rely on emotions or intuition. Even those who theoretically know how to integrate and operate cotangents on paper, in practical life tend to add and subtract only.
A group of psychologists led by Kahneman showed the scientific community that the human factor is not secondary but overriding in economic, political or financial vicissitudes. But, in essence, they said that the human being is the main thing! That cold rationality, which lives in economic formulas, usually dies there. And man always does everything in his own way, with his inherent emotionality, stubbornness, instincts and even stupidity. And since there is no cold-blooded and rational person in nature, there is no (or exists in vanishingly small quantities) rational and cold-blooded investor!
And it is from this thesis that I start from when I set myself the task of teaching a private investor how to make money on the stock market. I try to go from the person himself. The first thing I need to convey to a novice investor is that he does not need a myriad of techanalysis indicators or hedging principles. An investor needs to have himself in mind first and foremost – after all, you don’t get a Nobel Prize for nothing.
To illustrate these conclusions, let us recall a textbook literary hero – Herman from Pushkin’s “Queen of Spades”. Although the stock market is not gambling, some psychological aspects may be similar. Herman was a military engineer, so in those years he was already familiar with probability theory and risk management criteria. He was a cold-blooded German, who neglected the temptation in ordinary life, having accepted the risk of the game, “to put at stake enough to acquire the excess”. But for every wise man there is simplicity. When dreams and passions interfered with his budget and finances, the cold-blooded engineer was gone!
But the simplest principle of capital management would not only have saved him, but also enriched him. Herman should not have put all the capital at stake in every hand in his fatal game – then he would not have been bankrupt. At the same time, though, the profits would have lost their demonic appeal….. And here we see the reason that does not allow modern investors to accumulate returns from their investments in a systematic, unhurried, steady dynamics. This reason is unrestrained maximalism. It is either everything or nothing.
Perhaps a private investor should start by debunking the myth about his rationality, his ability to quickly understand everything and pump the current cash flows into his pocket.
The myth of the rational investor is insidious, in my opinion, because it is a myth of the investor himself, even an unconscious internal attitude. Why does an investor get into the meat grinder of financial crises time after time? Because Kahneman, our Nobel Prize-winning psychologist, has a syndrome in him. At some point, for some reason, the investor stops being rational. Let’s say he bought Gazprom shares at 170$ and saw them rise to almost 190$ . And do you know what happened? Somewhere in his heart he believed that now it will always be like this, that the stock will only grow and he doesn’t have to take care of anything. And this is already irrational behavior, this is already intuition, faith. In this case, reason, common sense is removed from the consulting room. All actions are dictated by an uncomplicated slogan “everything will be fine”. This was exactly what happened to American investors in 1929. Economists, analysts in their majority wrote and said right on the eve of the collapse – growth will continue and will be steady.
Let’s return to the position investor in Gazprom shares. Let’s assume that they are now worth 170$ again. In the first weeks, when the shares were declining, the investor was patient and hopeful. After all, when he made a deal, he was not buying shares, but a dream. A dream to get rich on the stock market. And when the quotes went down, instead of cutting losses (or locking in a small profit), the investor begins to feel cheated.
Therefore, it is very important to distance your personality from your stock trading endeavors. Briefly, this means making your trading a business. By exactly the same laws that govern any other business. We will have to write a business plan (this is our strategy, in which we determine where, why and for what size portfolio we buy, and where and why we sell), we determine logistics, document flow, accounting and control. And accountability is a very important point. Your stock trading should mimic a professional environment where responsibility is clearly defined. A private investor has a void here, so his behavior at a certain point becomes irrational, even infantile.
For beginner traders, it is important to first learn very simple strategies in which everything is obvious, and then move on to something more complex. That is, at the beginning of a beginner’s journey, the main factor is discipline. Literally, like in the army – do it once, do it twice, without amateurishness, up to automaticity.
Another critical point, in my opinion, is the attitude towards losses. They are inevitable as a business risk in any complex activity related to finance. And now a trader gets his first loss. What is his reaction? Get depressed, get angry or give up? No, a person who aims at long-term success, not at the fate of one single transaction, should turn on critical thinking. He will notice something in his method that he has not seen before, some vulnerability, and figure out how to deal with that weakness.
Probability theory was discovered for predicting the odds of betting players. As far as trading is concerned, it has its own meaning, applicability and limitations. And if a private investor understands the nature of market risks and probabilities and has discipline, he will certainly succeed. In other words, the sooner the novice investor moves from emotional “dream buying” to cold-blooded risk buying, the sooner their operations can actually meet their day-to-day financial needs.
This can be interesting:
- 1. Video Tutorials: Psychology is the key to investor success
- 2. Notes of a Stock Psychologist: The Myth of the Rational Investor
- 3. Notes of a stock exchange psychologist: Why losses occur and how to deal with them
- 4. When to invest in the stock market? When is the scariest time to decide to do it!
- 5. World history of economic «bubbles»
- 6. How to make money on market bubbles
- 7. 10 mistakes of a beginning trader on the stock market. What not to do
- 8. I bought a stock, but it’s going down. What to do
- 9. What economic crises teach us