The Psychology of Trading
Trading choices are often subject to our emotions and psychology. This results in several mistakes that make our trading experience a regretful one. For example, we often choose to invest in company stocks according to our own affinity to the products they sell. We can like the products of a company, but that does not make the company a profitable one, and that does not mean it has real potential for growth. It is the profitability and the growth perspectives of a company that matters, not our own appreciation of its products.
Another common bias is related to our own trading history of a specific stock. We tend to think that the market price of a stock behaves according to our own experience in trading this stock. For instance, if we buy a stock at a specific price, we tend to think that the market price will go back to the price at we purchased the stock. That bias is related to the fact that we are usually reluctant to admit our errors and that we always believe that we will end up making a profit.
This behavioral mistake pushes many traders to buy more of their favorite stock even when its price is dropping, thus justifying this behavior as an “averaging down” of the purchase price, while in effect, they are actually increasing their exposure to a declining stock, which price might never recover. We should also be aware when analyzing charts not to foresee a trend that matches our own hopes. Such behavior would be based more on wishful thinking and guessing rather than on accurate analysis.