Understanding emotions to invest and trade stocks wisely
Decision making is at the core of stock management. It has rational components and emotional ones. Emotional intelligence is now recognized as a full part of intelligence and persons can be helped to improve it. This knol attempts to collect material regarding the emotional intelligence aspect of stock trading.
- Understanding / mastering one's own emotions,
- Understanding the emotions of others,
- Using those understanding for the benefit of all.
The human factor in trading and the role of emotions
However important are technical abilities and economic competences for stock traders and stock dealers, the human factor also plays a crucial part.
The Behavioral finance research explored various behavioral biases that are exhibited by people in financial decision making. Some of these biases are cognitive or caused by habits, but many are emotional. They occur because many people are not emotionally intelligent. While stock traders and dealers who remained in the trade for a long period of time have a good knowledge of trading methods and history of up and down trends in the markets, their emotional intelligence may be short of the high order required for successful trading.
Many behavioral finance research papers have documented the biases exhibited by professionals in the finance field. This calls for developing a training module to improve the emotional intelligence of stock traders and stock dealers.
Most professional stock traders have a very good grounding in the economic factors involved in trading stocks. Less or no attention is given to the fact that human beings are emotional beings and that emotional intelligence is a factor in most trades especially as many times stock trading follows a herd mentality. We will explain in this knol the science of developing our emotional intelligence strategies in relation to trading stocks.
Emotions can be defined, to make it simple, as painful or pleasant feelings that activate the brain. Neuroscientists have found brain areas and brain secretions that are directly related to emotions, including in trading decision situations (this is the area of "neurofinance"). Also experimental economics have studied how decisions are made among groups of traders acting in simulated markets.
Emotional aspects that traders should be aware of
Positive or negative energy
Emotions are forms of energy. Energy can be constructive or destructive.
- Whatever the automaticity of some of their behaviors, human beings are not just cold mechanical beings. Emotions are usually needed to drive their actions. A lack of emotion kills the desire to act.
- On the other hand too strong emotions, expressing excessive pain or elation, can overwhelm rational thinking and wisdom, affect perception, representation and decision making.
Neurosciences have brought various findings about that "primacy of emotions" in many decisions,
and specifically in money-related decisions.
Therefore emotions can be useful as well as harmful for traders.
They better check what emotions take a part in their decisions and whether they lead to rational / effective attitudes, choices and behaviors or to behavioral biases. Methods to cool down the brain areas and inner chemical secretions that can lead to the primacy of emotions over dispassionate thinking might help.
The emotions that might impact trading
Here are the most common emotional phenomena (some more or less biased, some others neutral, and some others still more or less constructive, as everything is a matter of degree) to be aware of:
- Greed / hope / optimism / wishful thinking, and even magical thinking and illusion of control.
- Fear / aversion / pessimism.
- Sometimes compensated by inventing "good stories" and false beliefs to avoid the pain created by the unknown, the fundamental uncertainty of a complex and changing world
- Emotional asymmetry: the prospect theory shows how players tend to give more mental value to losses than to gain.
- Mental accounts: different risk attitudes / changes of risk attitude according the origins of funds (savings or windfalls). Also forgetting to take into account transaction costs, inflation...
- Haste and hyperactivity (noise trading...) - or procrastination.
- Stress control vs. collapse under stress and uncertainty.
- Willpower and discipline ...or the lack or them making for erratic or counterproductive behavior.
- Getting carried away from one's goals by uncontrolled emotions.
- Independence - Mixed or not with empathy.
- Affect heuristic (personalization): deciding in relation with the pleasant or unpleasant feeling towards a person or an organisation more than via an objective analysis. Madoff's clients liked him!
- Mimicry, obedience, peer pressure, herd mentality, consensus.
- Also excessive trust in analysts, experts and medias.
- "Foot in the door" (emotional commitment to previous decision, endowment as the feeling that what is owned has more value than what the market offers).
- Overconfidence / pride / narcissism / hubris / illusion of competence or knowledge.
- Envy, a negative feeling towards colleagues which successes are considered undeserved. Such rivalry can lead to disastrous risk taking.
- Neither over- / under- confidence: selflessness / objective wisdom.
- Clear or fuzzy motives? What preferences (are they transitive?), goals, needs, motivations ? Do actions have a good chance to meet the goals (a definition of rationality) ? And are those goals themselves "rational" (here in the sense of as far as possible non damaging)? Is for example status / trophy seeking erasing a sense of rational self-interest?
- Anchoring to previous reference price or previous situation or previous paradigm. Here we enter into selection biases, focusing on an element and neglecting other, because of cognitive limitations but often also because it would be emotionnally unpleasant to consider other possibilities (cognitive dissonance).
- Autopilot behavior (habits, reflexes, even addictions). Although here, emotion as well as cognition are both bypassed by automatic "physical' reactions to stimuli.
Effects of collective emotions on financial markets
Another thing traders might try to detect and take into accounts, are collective emotions that might distort or at least influence the general market behaviors and performances (prices, returns, volatility).
Also, attitudes might differ or converge between the main categories of players.
Here are some of the effects to be aware of:
- Market mood / sentiment (collective optimism / pessimism), herd instinct.
- Mistaken collective reactions to events and to information.
- Also underreaction - overreaction by the bulk of market players.
- Trends, cycles, bubbles, crashes, as a result of this underreaction - overreaction collective process
- Collective overconfidence that brings a neglect of - and impreparation for - "rare events" that might destabilize the whole system, for example leading to a systemic liquidity crisis.
- Price and return anomalies / inefficiencies (market distortions that contradict the "Efficient Market Hypothesis")
- Industry rotation (either short term as market fads and fashions, or long term as industry life cycles)
- Some manipulations by purported experts playing the greed or fear game.
- Stock value perception, stock image
- And so on...
A two step method / counter-measure inspired by behavioral finance research comprises debiasing (correcting the emotional components of market prices / market returns/ market trends) and rebiasing (trying to project how those components will evolve in the future).
The "trick" can be used in stock markets at the stock valuation level (for example by using the stock image coefficient), or at the trend spotting level when looking at misreactions (under-reaction / overreaction notably).
Emotional Competence Inventory
Emotional Competence Inventory 2.0 is tool designed to assess emotional and social competence in individuals working in organizations
The ECI measures 18 competencies organized into four clusters:
Social Awareness, and
Self-Awareness concerns knowing one's internal states, preferences, resources, and intuitions.
The Self-Awareness cluster contains three competencies:
- Emotional Awareness: Recognizing one's emotions and their effects
- Accurate Self-Assessment: Knowing one's strengths and limits
- Self-Confidence: A strong sense of one's self-worth and capabilities
Self-Management refers to managing ones' internal states, impulses, and resources.
The Self-Management cluster contains six competencies:
- Emotional Self-Control: Keeping disruptive emotions and impulses in check
- Transparency: Maintaining integrity, acting congruently with one’s values
- Adaptability: Flexibility in handling change
- Achievement: Striving to improve or meeting a standard of excellence
- Initiative: Readiness to act on opportunities
- Optimism: Persistence in pursuing goals despite obstacles and setbacks
Social Awareness refers to how people handle relationships and awareness of others’ feelings, needs, and concerns. The Social Awareness cluster contains three competencies:
- Empathy: Sensing others' feelings and perspectives, and taking an active interest in their concerns
- Organizational Awareness: Reading a group's emotional currents and power relationships
- Service Orientation: Anticipating, recognizing, and meeting customers' needs
Relationship Management concerns the skill or adeptness at inducing desirable responses in others.
The Relationship Management cluster contains six competencies:
- Developing Others: Sensing others' development needs and bolstering their abilities
- Inspirational Leadership: Inspiring and guiding individuals and groups
- Change Catalyst: Initiating or managing change
- Influence: Wielding effective tactics for persuasion
- Conflict Management: Negotiating and resolving disagreements
- Teamwork & Collaboration: Working with others toward shared goals. Creating group synergy in pursuing collective goals.
For all human behavior including stock trading and handling finances wisdom is an essential ingredient especially for secure and wise trading.Once one becomes wise then not only will it help in fiances it will also help in all of life's situations. In fact the herd mentality and panic behavior has been ingrained in us since before the stone age and it surfaces in us from time to time in group behavior. The only time individuals are free of these is when individuals are emotionally super mature. Again greed is an attribute of ignorance, the lowest -2 mind level. Yet greed emerges even in +1 individuals because the +1 individuals behavior is many times powered by more zeal than knowledge. The zeal to make more and more; pushed on to accomplish the goals of the +1 trophy self image. So here again wisdom is the missing ingredient. Thus stock brokers must be regulated and must pass a certification test which must include a wisdom test.
As there are four levels of the mind as follows:
1) Premature mind of a new born child quantified with a value of negative 2.
2) Immature mind of a teenager quantified with a value of negative 1.
3) Mature mind of an adult quantified with a value of positive 1.
4) Super mature mind of a master quantified with a value of positive 2.
There are grown up people who are +2 in their profession qualifications and yet are -2 in emotional intelligence. There are many such people in every industry. We must create tests to detect such people who should be barred from any financial dealings. My wisdom test can be effective but such people will cheat on the test so it must be given on a lie detector. Again emotionally -1 people must also be barred from becoming stock brokers. Only +1 and +2 people may be certified as stock brokers.
So all those experts who are racing to create an effective financial model must make wisdom behavior as its chief pillar along with the current financial expertise. Thus we can have a business model that requires expertise in the field of financial trading along with the emotional expertise to handle the trades wisely. We could call this model - 'Wisdom Finance'.
Wisdom finance can be the moat against the herd mentality, panic behavior and greed.
Emotional Intelligence - Some Resources
Emotional intelligence tests
75% of Fortune 500 companies use their tests, products and training.
Emotional Competence Inventory 2.0
Emotional & Social Competency Inventory
Investor Therapy, A Psychologist and Investing Guru tells you how to out-sych Wall Street, by Richard Geist, Crown Business, New York,2003
and take an Investment Personality questionnairre.
Wisdom/emotional intelligence coach education; The nuts and bolts of emotional intelligence/wisdom education.
Investment, Trading, Risk Psychology - Videos
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Originally posted in
http://knol.google.com/k/ improving-emotional-intelligence-of-stock-traders-and-stock-dealers Knol Number 1105