"Guess what! I found the best stock ever. No one knows about it and it's going to fly. You need to invest in it!"
Does that sound familiar? Or perhaps you were the one who was thinking you found the holy grail of stocks? There are few things that can negatively impact our returns more than emotions.
Trading stocks or other types of investments is often equated to gambling. I prefer to think of it as gambling with the ability to turn the odds in your favor. That being said, there's a lot of merit in the comparison. There's a high that you get when you win in gambling caused by the release of dopamine in your brain. This tells your body to feel elated because something good is happening/happened. Your body quickly gets addicted to this feeling and wants more and more, and this is what leads to addiction.
Soon you bet more and more often as your body craves dopamine. You begin to feel like you can't lose, and that's when you lose it all. However, you now want that feeling even more since you're beginning to feel the opposite emotions, and you keep betting thinking "well I have to win it back now." It's a vicious cycle that is very present in trading stocks.
When you think you have an amazing opportunity your brain gets excited, similar to winning in gambling. You think you can't lose and stop thinking rationally. The truth is that there is a phenomenon in the traditional stock market called the Efficient Market Hypothesis. This states that the market immediately and accurately reflects all available information. In layman's terms, this means that any new press release, the time of the day, future probable events or product launches, are already reflected in the price. In essence, you can not gain arbitrage, or an advantage over the market.
For more information on this phenomenon, check out my post - https://steemit.com/finance/@irishfan686/finance-101-the-efficient-market-hypothesis-impact-on-financial-markets
The following are examples of scenarios where I personally have experienced emotions in trading, and tips on how to protect yourself from making decisions that cause you a financial loss:
When someone tells you that they have a stock that is going to generate HUGE returns
- Remember the efficient market hypothesis
- Analyze the stock with your own criteria. Do your own research, and if you find that it's a good investment with your own merit, think about investing
You just hopped into a stock, and as soon as you did it crashed by 5%
- Think to yourself - is this a long-term or short-term investment?
- If it's a long-term investment, re-evaluate the investment and perhaps stay in the stock
- If it's a short-term investment, it may be better to cut your losses and accept you're wrong. At the minimum evaluate the possible impact to your portfolio and how many future trades you'd have to win to make back your losses.
- Don't be afraid to cut your losses!
- Too many people get stuck thinking that their stock can't fail and that they're going to recoup their losses
- Sometimes you're wrong and it's incredibly important to take the loss and then work on the next trade to regain those losses
You've been in a stock that's been soaring. It's up 50% since you got in and you don't see a limit!
- Remember the saying "what goes up must come down." Eventually, the stock is likely to decline to some previous resistance point.
- You don't need to take out all of your investment, but rather scale out of it. If it declines then you could reinvest at a cheaper price, or you get to realize your gains and not lose them!
These are a few typical scenarios where your emotions will be pulling you towards making irrational decisions. If you find yourself slipping away from rational thinking, take a quick break and then analyze your stock without any of your emotions influencing your decisions. Always remembering that trading and emotions don't mix well will help you on your way to winning the investment game.
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