Mastering the Mental Game: Behavioural Insights for Optimal Trading Psychology
Portfolio managers and traders face numerous challenges in a daily shifting landscape, not least of which is managing their own psychology. The ability to make value-adding decisions consistently demands a deep understanding of one’s own thought processes, emotions and behavioural tendencies as well as technical knowledge and market / investment analysis. This blog post explores key behavioural insights that investors can use to optimise their psychology and enhance their decision-making capabilities.
Understanding the role of emotions in trading and investment
Emotions are the drivers of our actions as human beings. Insofar as making a decision is an action that you take, your decision is driven in a large part by the contemporaneous emotions that you are experiencing. Hence emotions often influence investment and trading decisions much more than, as professionals, we may like to admit. Emotions are not external forces disrupting an otherwise rational process, but integral components of decision-making itself.
FOUR KEY FUNCTIONS OF EMOTIONS IN DECISION MAKING:
Preference Construction: Emotions help form preferences by providing and filtering evaluative information about potential consequences of a decision.
Speed: Emotional states can accelerate information processing, enabling quicker decisions when time is of the essence. They can also cause us to rush into decisions. On the other hand, emotions can slow us down from making reactive decisions too quickly and create space for more proactive, considered decisions. There’s also the downside risk of a ‘Freeze’ response when fear is in play.
Assigning Relevance: Emotions impact our choice of factors in determining which are most relevant to a given situation.
Commitment: Emotional investment in a decision can help traders and investors hold fast against moving with the herd. But emotional investment can also drive loss aversion and a common behavioural pattern of holding losing positions for too long.
Understanding these functions allows us to harness emotions productively rather than attempting to eliminate them entirely. The goal is not to become unemotional, but to cultivate appropriate emotional responses that lead to value-add investment and trading decisions.
Strategies for Emotional Management
MINDFULNESS AND MEDITATION
Anecdotally, meditation practice is reported to correlate with improved trading performance, particularly with respect to maintaining perspective on newsflow and market moves, and trading discipline on strategy and limits. Benefits include: improved ability to stay calm, reduced stress and anxiety, enhanced focus, increased patience, increased EQ in interactions with others.
JOURNALLING
Keeping a detailed record of trades, emotions and thought processes is a powerful tool for identifying patterns and making necessary adjustments to trading plans and investment decisions. The practice promotes self-awareness and helps investors recognise recurring emotional triggers or cognitive biases that may be impacting their performance. Sharing the journal with your team can be hugely beneficial in promoting creative thinking around trading and investment strategies, garnering other perspectives and feedback and educating junior members on how they can contribute most helpfully.
Cognitive biases and their impact on trading
Awareness of common cognitive biases is essential for investors to optimise their decision-making processes. Truth be told, everyone has their own individual recipe of biases and heuristics and how these interplay. But being aware of the big ones will help:
Over-confidence: can lead to excessive risk-taking and ill-disciplined decision-making.
Loss aversion: the tendency to feel losses more acutely than equivalent gains can cause you to sit on losing positions too long or exit early from winners.
Confirmation bias: seeking out information that confirms existing beliefs while ignoring contradictory evidence.
Endowment bias: valuing an investment you own more than if you did not own it. Also called divestiture aversion.
Seeking out diverse perspectives and challenging your thinking regularly is crucial, as well as making decisions ahead of time (e.g. stops and taking profit levels) to manage your in-the-moment traits. Coaching can help enormously in providing a valuable space for this type of regular thinking and planning. Contact Park Street to learn more.
Developing a Disciplined Approach
Discipline is the cornerstone of successful investing. A few strategies that have been shown to enhance trading decisions:
SETTING REALISTIC GOALS
Establishing clear, achievable goals provides direction and focus, helping to prevent impulsive or overly aggressive trading decisions. It’s important to realise that the goals that make business sense don’t always make “I know how to do this” sense to your brain. Breaking annual or quarterly targets down into monthly or weekly trading strategies that compound to hit or reach through the bigger goals makes them doable and facilitates much more consistent trading discipline.
IMPLEMENTING A PRE-TRADING ROUTINE
Developing a consistent pre-trading routine can help condition the mind to enter a focused and disciplined state. This might include reviewing market and macro news, breathing exercises to calm the mind, walking to work, reviewing trading plans and strategies for the day. What works for you?
SPECIFIC RISK MANAGEMENT STRATEGIES
Whether these include avoiding leverage, setting limits on trading capital per position, setting draw down limits, or explicit risk-reward ratios, the key is that your risk management strategies have specifically appropriate rationale that protect and help, not hinder, your trading. Different risk management strategies will work for different trading and investment styles. Getting psychologically on board with your risk management strategies is essential.
Cultivating emotional resilience
Emotional resilience is crucial for weathering the inevitable ups and downs of trading. The most effective tools that I have seen in practice are:
SOMATIC EXERCISES AND BREATHING
To bring yourself out of the clutches of a dominant emotion and back to a grounded perspective, physically use your body and your breath. Slowly clench and unclench your fists or curl and uncurl your toes in 5 second pulses each way. Or flex and unflex your ankles for a minute or two. Your breath is also key. Inhale deep through your nose, hold with intention for 3 counts at the top of the breath and exhale it all out for twice as long as the inhale. 3 breaths like that will engage the parasympathetic nervous system and allow for clarity and perspective to return to your thinking and decision-making.
RESTORATIVE BREAKS
The human brain has been shown to focus optimally for periods up to 90 to 120 minutes. If you have the discipline of taking restorative short breaks to physically stand up and move about when market conditions allow, you will have energetic reserves available to you when they don’t. You’ll also get more efficient as using those breaks, which can means that you still benefit even when only shorter breaks are possible.
ALLOW THE EMOTION
It’s alright to feel like shit, be frustrated, anxious or mad. Allow it! Have a five minute funeral for your disappointed hopes or expectations and then recentre with the techniques above and move on. Allowing and acknowledging the emotion facilitates your ability to look forward and move on.
COACHING
The value of making regular time to gain perspective and develop your self-management skills with input from a behavioural expert cannot be overstated: coaching clients benefit from reduced stress, more clarity, more perspective and more focused thinking for optimal tangible outcomes. All of which are reflected in more robust investment and trading decisions. Park Street specialises in exactly this type of support for traders and fund managers. Contact us to learn more.
Advanced psychological techniques
IDENTITY WORK
Consciously and intentionally building your self-concept as a trader can lead to profound changes in behaviour and decision-making. The focus of this work is not so much to correct sub-optimal behavioural traits, but to holistically cultivate optimal daily habits and practices that build your consistency in making the best trading decisions, which align with your ultimate trading goals and broader personal desires. This is deep work that takes time and benefits enormously from regular behavioural coaching.
COGNITIVE BEHAVIOURAL TECHNIQUES
Learning to identify unintentional thinking, emotional and behavioural patterns boosts your ability to manage detrimental behaviours and sub-optimal decision-making. With unintentional models in play you are reacting to circumstances - an automatically higher stress and constrained position that hampers decision-making. Developing your ability to build and implement intentional models for best decisions, puts you on the front foot, in creative, proactive mode, and gives you a tool to use in any set of circumstances that require high-impact decisions and / or emotional discipline.
Conclusion: the path to consistent profitability
Mastering trading psychology is an on-going journey that requires commitment, self-awareness and intentional effort. By understanding the role of emotions in decision-making, recognising cognitive biases, developing disciplined approaches, cultivating emotional resilience, and learning some more advanced psychological techniques, traders can significantly improve their ability to achieve consistent profitability.
The key is to view trading not just as financial endeavour but a psychological one as well. By managing your brain as an essential tool in the trading arsenal and consistently working to sharpen it, traders can develop the mental edge necessary to navigate complexity and weather turbulence in financial markets.
Ultimately the most successful traders are those who can maintain emotional equilibrium, make rational decisions based on sound analysis and adapt to changing market conditions. Integrating behavioural insights into your trading approach allows you to optimise your psychology for making value-adding decisions consistently… without burning out or blowing up.