The Psychology of Decision-Making (For Beginner Traders)

Key Takeaways:

• Emotions can cloud judgment and lead to impulsive decisions
• Beginner traders should know about all the tricks our minds pull on us
• There are proven ways of dealing with this important topic

Study after study proves that the vast majority of traders lose money. And although it seems like a fun way to supplement your income or a gateway to financial independence, for most, it’s just a quick way to drain their savings account.

But why is that so? Why does trading usually end up in the red, and can you be successful? Understanding the Psychology Behind Financial Choices

Ever wonder why some investors and traders make it big, and others just keep losing money and give up eventually?

It’s not a coincidence. Successful traders understand how our brains work.

Norman Welz, author of the book on trading psychology Tradingpsychologie, says that “trading is the most insecure business you can be in” and that “success comes from the head.”

Trading stocks is like playing a high-stakes game of risk and reward. Our brains are wired to weigh the potential gains against the possible losses, but sometimes, we’re not so good at accurately assessing those risks.

In fact, our brains play tricks on us all the time and make us ignore warning signs or make us only pay attention to things that confirm what we want to believe.

And then we also have the all-encompassing pressure to make sound decisions coupled with the adrenaline rush of winning or losing money.

After a while, this leads to so much stress, anxiety, and even addiction. I mean, watching the candles all day is a reality for many traders, right?

And because many traders and investors actively want to know what others are doing, they can also easily become victims of herd mentality.

When they see others making quick profits, they’re tempted to jump on the bandwagon, regardless of the underlying fundamentals.

Now, let me expand on how our emotions rule over us and what that means for you as a trader.

The Role of Emotions in Decision-Making

“The stock market is a device for transferring money from the impatient to the patient.” – Warren Buffett

Emotions are the engine driving our emotions. It doesn’t matter if you’re buying shoes, lunch, stocks, or options.

They can either be your best friend or your worst enemy, depending on how you handle them.

Take fear, for example. It’s a primal instinct that kicks in when we sense danger, like when the market takes a nosedive. Our first instinct is often to panic and sell everything before it’s too late.

Also, many traders and investors have only ever invested in a bull market. They still haven’t faced what a real bear market looks like.

There’s a well-known saying that everyone is a genius in a bull market. The money is cheap and abundant and people can take more risks.

People get greedy and have that insatiable desire for more. More money, more success, more everything.

When the market’s on fire and everyone’s making bank, it’s easy to get swept up in the frenzy and throw caution to the wind.

But chasing profits blindly can lead you to make risky decisions that end in disaster.

Apart from fear and greed, there are also:

• Anxiety (feeling worried or nervous about the market’s movements or your investment decisions)
• Confidence (being self-assured about your trading strategy, sometimes to the point of overconfidence)
• Regret (feeling remorseful about past trading decisions)
• Hope (being optimistic about trades or future market movements)
• Frustration (feeling annoyed or irritated when trades don’t go as planned or when the market behaves unpredictably)

And don’t let me get started on cognitive bias, as it can singlehandedly distort perception, affect judgment, and influence your trading behavior.

For instance, you think you’re better at trading than you actually are and so you take on too much risk, overleverage, and ignore the facts.

Or you only pay attention to news and analysis that confirms your beliefs about a stock and you’re ignoring all the other information proving you otherwise.

Understanding Risk Perception

“The stock market is filled with individuals who know the price of everything but the value of nothing.” – Philip Fisher

Just as some people are successful traders, some people are comfortable skydiving or rock climbing, for example, while others break into a cold sweat at the thought of crossing a busy street.

It’s all about our risk perception, isn’t it? It’s the way we perceive and evaluate the potential dangers of situations.

When you think of risk, what do you think of? Perhaps you think of the likelihood of something bad happening.

But it’s more than that. Research shows it’s influenced by our emotions, gut feelings, past experiences, and even how the information is presented to us.

For example, you’re thinking of investing in a mutual fund. Fund A is marketed as “Seeking steady growth? Choose Fund A. With a focus on stability and consistent returns, it’s ideal for cautious investors.”

On the other hand, Fund B is described as “Want high potential returns? Opt for Fund B. It’s for bold investors ready to take risks for the chance of substantial growth.”

Under the hood, both funds have similar historical performance and will likely give you an average annual return rate of around 8%.

But, because they’re presented differently, you form a different opinion about them until you look at their fundamentals.

Now, obviously, trading is different than flat-out investing in ETFs, stocks, etc. However, even for traders, looking at information from different angles is very important. Even more so.

And when I talk about past experiences influencing your risk perception, let’s consider you had a bad experience investing in real estate during the 2008 financial crisis.

Now, even though the housing market has recovered and is thriving, you’re hesitant to invest again because you lost a lot of money in the past.

People hang on to thoughts like that all the time, and in many cases, they don’t even know that they’re doing it.

The Psychology of Buying and Selling

“In investing, what is comfortable is rarely profitable.” – Robert Arnott

Understanding the psychological factors that drive your actions can mean the difference between profit and losing your shirt in the market.

If you understand why you do what you do, you’re more likely to come out on top and avoid big losses.

Let’s start with buying. When you’re eyeing a stock, there’s a rush of excitement and anticipation. Maybe it’s a hot tip from a friend or a promising trend you’ve spotted.

Whatever the reason, your brain releases dopamine, the feel-good chemical that makes you eager to pull the trigger.

But as we know, emotions can seriously cloud your judgment. They can make you ignore warning signs or convince you that this time things will be different.

It’s easy to get caught up in the hype and make impulsive decisions you’ll regret later.

Knowing when to sell is a whole other ball game. For example, even if the stock has hit your target price or it’s starting to show signs of weakness, you’re hesitating to sell.

You’re going through so many emotions. What if you hold onto it for a bit longer? It has so much potential for gains, you’re telling yourself.

You simply must understand the emotional drivers behind your actions to become a more confident and disciplined trader or investor.

For that, I recommend reading (a couple of times) a book called The Psychology of Trading Tools and Techniques for Minding the Markets by Brett N. Steenbarger.

What do Professional Traders do Differently Then?

“The four most dangerous words in investing are: ‘This time it’s different.’” – Sir John Templeton

Professional traders achieve success through a combination of:

• Technical analysis
• Rigorous risk management
• Preparation
• Emotional discipline
• Adaptability
• Continuous learning
• Efficient trade execution
• Focus on trading liquid stocks

In other words, they succeed by combining skill, discipline, and a detailed understanding of the markets to capitalize on trading opportunities while managing risk effectively.

So, if you’re a beginner trader, what can you learn from all of this?

Tips For Beginner Traders

Everyone was a beginner trader at some point. The key for you is to get to grips with the psychology of trading, coupled with basics, of course.

You need to educate yourself about the markets, trading strategies, and risk management techniques because, and I can’t stress this enough, preparation and research are crucial for making informed decisions and minimizing your losses.

Next, instead of jumping in with large sums of money, you should start small and focus on managing risk.

This means using stop-loss orders, setting realistic profit targets, and only risking a small portion of your capital on each trade.

You should also know that markets are constantly evolving, right? That’s why staying on top of learning new trading strategies, studying market trends, and analyzing your own trading performance to improve over time is like a full-time job.

And lastly, before risking real money, you really should practice trading with simulated accounts or paper trading platforms for as long as you can.

They allow you to get experience and confidence without the risk of losing money.

Besides, the best trading simulators mimic real-life, real-time trading scenarios and offer you distilled knowledge from the best finance books and courses. They’re the perfect gateway to the real thing.