Psychology of Investing: The Market Emotions Cycle
by Eric Kidder
It is a recognized fact that psychology plays an important role in forex trading. Anyone who has experienced the euphoria of a series of wins knows that the feeling is invigorating—and deceiving.
Anyone who has experienced a long series of losses knows that the depression is debilitating. In either case, you lose your grasp on reality because of the emotions you experience.
But most people fail to recognize how much this factor does affect their trading practices. It is all too easy to assume that you have the confidence to handle bumpy times. In fact, it is only been in the 20th century that economists began recognizing behavioral economics as a distinct and important discipline.
Every few years, a graph of the market emotions cycle makes its rounds across the internet and email networks—usually after a big bust. The sine curve carries investors up through optimism, excitement and thrill to euphoria. At this point, investors are at the point of maximum financial risk and feeling really smart—maybe even considering themselves to be a financial genius. The next stage carries through anxiety, denial, fear, desperation, panic, and despair. Some investors consider leaving the market altogether with the assumption that it’s all rigged. This is the point of maximum financial opportunity. If investors stay in, they’re back on the road through hope, relief and optimism.
As anyone knows, this is over-simplistic, but points to something realistic. The ebb and flow of the markets at large through the business cycle is also mirrored in a very personal, emotional cycle for individuals. A person’s ability to recognize and manage that cycle is one of the many factors that will define their success.
What makes this worse is the comparison to other investors—generally unrealistically. There have been entire books commending excessive risk as a trading strategy and comparing day-trading to poker. For instance, newspapers are constantly profiling traders who quit their day jobs to become day traders with obscene profits.
Comparing your profits to this is like letting your son put all of his future hopes and plans into joining the NBA. Maybe it will happen; probably it won’t. Living with that in front of you every day will make you depressed, and worse, it will make you perform below your potential.
Compared to trading securities, forex trading is even worse in this respect. This is true for several reasons. To begin, forex brokers tend to be extremely aggressive in their marketing and promise returns that almost nobody makes. Second, the forex market inherently depends on leverage and margin trading that make the possibilities even riskier.
Finally, forex trading tends to be shorter term and involves constant decisions, depending on the particular trading strategy you use. If you are controlled by your emotions, this can lead you to make decisions based on what you’re feeling rather than what makes sense.
What’s the solution? For starters, know yourself. Know how successes and failures affect you and try to counteract for it. Look at your trading history and gain insight into the way you’re wired. Second, try using an objective analysis tool, such as your z-score. This will help you see whether your forex trading really does come in trends. Most importantly, work out an objective forex strategy to guide your actions, and follow it. Most of the biggest trading losses happen when individuals decide that an opportunity is too big to miss and revamp their strategy on the spot. All of this will take a lot of time, but it can save you a lot of money, and after all, isn’t that what forex trading is all about?