Finance Psychology:

How To Begin Thinking Like A Professional Trader

(This Workbook About Behavioral Finance Is All You Need To Be Successful In Trading)

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Finance Psychology: How To Begin Thinking Like A Professional Trader

Financial psychology - origin until today

Framing effect

Sunk cost effect

Heuristics

Disposition Effect

Trading Fears - The central issue in trading

Meaningful fears and meaningless anxieties

The longing for security

The view of things

The control center in the brain

The power of the unconscious

Statements of faith

Autoaggression (self injury)

Which characterize the first years of life

The power of discipline - training the will

Stress and trading - the right dose makes the difference

Combat escape response

Stress due to loss of control

Recognizing and overcoming stress

Trading and personality

Trading trap: Thinking, believing, hoping

Small trading account - big problems

Trading with sense

Finance Psychology: How To Begin Thinking Like A Professional Trader

Trading psychology is becoming more and more important for investors. Even the newcomers to this business increasingly understand that the psyche plays a very important role in order to be successful on the stock exchange. No wonder, since the constant ups and downs on the markets are largely caused by the emotions such as fear and greed of speculators themselves.

Professional traders assume that about 80 percent of trading success is determined by the psyche. Some even speak of 100 percent. Scientific studies on this topic also clearly prove: Above all emotions decide on victory or defeat, especially fears have a great effect. After all, they significantly influence the actions of the players. In addition, excessive expectations and illogical patterns of thought and behavior make the path to profitable trading more difficult.

At the beginning, trading seems to be a kind of Formula 1 race of money multiplication for many. If one takes a closer look at the wishes of the trading beginner on a psychological level, his all too human intention becomes clear: he wants fast, secure profits and usually completely ignores the risk of loss. Moreover, many people do not want to take responsibility for their trading decisions. Instead, they blame others for mistakes or losses.

Professionals behave differently. For them, trading is a professional business, which is mainly determined by risk. They see their task as managing it. To do so, they need certain previous knowledge and skills.

In the following chapters, you can read about the mental ways of thinking and acting that are necessary to be permanently profitable on the speculative capital market. But you will also learn how to expose typical mistakes and how to eliminate them effectively.

I hope you enjoy reading it.

Financial psychology - origin until today

Financial psychology is a relatively young branch of psychology. It investigates how people behave and experience when dealing with money or money-related products. This science focuses primarily on the perception and processing of information related to financial products.

In the financial sector, the research area of Behavorial Finance has stood out. This field of research emerged in the early eighties in the USA. It combines traditional economic research methods with expert knowledge of psychology. The research results of Behavioral Finance can help private investors and professionals to better understand their actual motives for investment decisions on the speculative capital market. They make it clear according to which patterns of thought and behaviour the players usually act.

Behavioral Finance assumes that investors act in an illogical way, mainly due to unconscious behavior. There is a well-known saying: "If you want to be smarter than the market, you have already lost. If you are aware of your irrational behaviour, you have a chance".

The fact that stock market events do not result exclusively from rational behaviour was described by the eminent economic theorist John Maynard Keynes as early as 1936 in his major work "The General Theory of Employment, Interest and Money". However, the true causes of irrational behaviour in risky transactions were proven in 1979 by the research paper "Prospect Theory". The two economists Daniel Kahneman and Amos Tversky recognized that people usually do not like risk - unless they are about to lose. Then they love risk. This "Prospect Theory" by Kahneman and Tversky, which is the foundation of modern finance, was awarded the Nobel Prize for Economics in 2002.

In the following years, Richard Thaler, Hersh Shefrin, Robert Shiller, Terence Odean and Martin Weber provided further in-depth knowledge in the field of behavioural economics.

Another key finding of Behavioral Finance research is that speculatively oriented traders are consciously or unconsciously guided primarily by their emotions. This inevitably leads to (wrong) decisions. Typical emotions are the fear of losing money when things are going badly and the greed for more money when things are going well.

Man has the urge to want to control events with the help of his knowledge. But precisely this is not possible on the speculative capital market, because the course of stock market prices is uncontrollable. The only thing the investor can control is himself, provided that he actively works on it. However, since the trader prefers the fast track, he is often not willing to go the long way of his own personal development. This usually takes a lot of time, sometimes months or even years. However, it is clear that the main reason for success in stock market trading is to be found on the mental side.

Typical thinking and behavioral patterns of Behavioral Finance research are Cognitive dissonance, framing effect, sunk cost effect and heuristics. These are discussed in more detail in the following chapters.

Framing effect

When people make a decision, they put it into a frame of reference and check their assessment for profit or loss. The two Nobel Prize winners Tversky and Kahneman (2000) recognized this and called it the "framing effect".

In simple terms, the framing effect means: "What am I looking at?" Numerous studies have proven that people evaluate the same results differently.

An example: In case A, you tell the subjects they can keep 20 euros. In case B, the test persons are told that they will lose 30 euros. The starting value is 50 euros. The result remains the same as minus 30 euros, but the assessment of the situation in case A is more positive.

Another example: A profit of 10 Euro to 20 Euro (100 percent) is generally felt more strongly by the individual than the profit of 1,000 Euro to 1,010 Euro. In absolute terms, the difference is 10 euros in each case.

In trading, the framing effect means that monetary amounts are not valued realistically. Anyone who earns 50 euros a day with a 50,000 euro account usually has the impression that this is too little. However, if you manage to earn 50 euros each on 200 trading days a year, this results in an annual return of 20 percent!

The lottery game shows that people prefer a sure win of, say, 500 euros, rather than exposing themselves to the risk of winning 1,000 euros with a 50 percent probability or possibly going away empty-handed. This is also one reason why traders find it so difficult to run winnings: They prefer to opt for immediate and safe profit taking rather than taking the chance of even higher profits.

The framing effect is also regularly used in retail. Shopkeepers know that customers prefer to buy a product when they get a discount. If a pair of trousers is reduced from 198 euros to 149 euros, the customer's decision to buy is made easier. The same trousers without a discount would not have been so popular with the customer for 149 euros.

Sunk cost effect

Translated into German, sunk cost means "sunk costs". These are costs that have already been incurred in the past and no longer play a role in the current valuation.

Here is an example: A trader buys shares at a unit price of 100 euros. A short time later the value of the investment is only 75 Euro per share. No one can predict whether these shares will ever reach the entry price again. However, many investors are prepared to reduce the price of the shares in this situation. So they throw good money after a perhaps bad investment and "sink" further money with it.

Exchange participants often base their decision to sell on the purchase price of the investment. However, the purchase price from the past is not important for the development of the future price. Only the investor himself gives significance to the purchase price. If we stick to unsuccessful projects despite better knowledge, we are dealing with the sunk cost effect.

This also includes holding on to stock market values that are already in the red. Instead of selling the assets with a small loss on the account, traders hold on to their positions and hope that the price will recover and the assets will return to their entry price if possible. However, this usually leads to even greater losses, as described above under "Cognitive Dissonance".

A structured trading plan helps to protect yourself from the fatal consequences of the sunk cost effect when trading. Stops should be accepted and positions taken should only be increased in the event of a profit, but never in the event of a loss.

Heuristics

Since the human brain can only process a small amount of information at the same time, it tends to simplify its decision making. These mental shortcuts help people to make quick decisions, but cause irrationality and a myriad of errors. In finance, these behaviours are called "heuristics".

Many investors choose certain investments because they are the focus of general interest. The "Deutsche Aktienindex" (DAX) is present in the media every day. Traders therefore often trade financial instruments that refer to the DAX, although other indices may provide much clearer price patterns. However, its high level of recognition creates the illusion of security among stock market players. They think they know the DAX and are therefore better able to assess its price development. However, sentiment analyses repeatedly prove the exact opposite.

Just because something is better known doesn't mean it has to be better. This is demonstrated time and again by numerous investments in local stocks. Comparable, but unknown companies from abroad can be much more profitable. But here too, the degree of familiarity of the companies creates a feeling of trust and security for the trader. Which is why shares of the own country are always preferred when investing.

The rapid availability of information is another aspect of plant behavior. They lead to distorted perceptions. In most cases, the stock market participant only needs a few indications to buy a certain share. This behaviour is called "rule of thumb decision". The constant attention in the media can lead to the fact that one thinks that a certain share is a must. Titles that are constantly discussed in trade journals or special online portals additionally support this behaviour.

Because of his limited receptivity, a person tends to unconsciously seek information that supports his own opinion. If a position is in loss, a trading beginner will get the impulse to look for good reasons why it will rise again. In this context, the Internet can become a problem. Because the large amount of information leads to finding even more evidence that one is holding one's position, even though many indications have long since spoken in favour of selling.

Another aspect are self-fulfilling prophecies. "Will the crash come in October?" These and similar headlines are featured in the media every year. But just because there have been a few very strong price setbacks this month, it doesn't have to be like this every year. But the constant sprinkling of the keyword "crash month of October" itself can influence events. The constant presence of news on a topic can generate interest among traders and thus lead to corresponding actions that ultimately move the market.

Disposition Effect

The disposition effect means that investors tend to realize small profits and increase losses. Behind this is an inner blockade. According to the principle "hope dies last", investors hold on to a loss position for far too long. The trader is convinced that as long as the minus is only on paper, it is not real. He also knows that he remains free of pain as long as he does not sell.

Gains and losses are also valued differently. Even professionals perceive positive and negative returns psychologically differently. If a trader makes a profit, this initial profit causes the most benefit. Although additional profits are perceived as positive, they are perceived with an ever decreasing tendency.

The reverse is true in the negative case. The first losses leave the deepest psychological traces. With time, however, a habituation effect sets in and the subsequent losses are no longer perceived with the same intensity, however high they may be.

In practice, the disposition effect leads to profits being realised far too early and losses far too late. This behaviour can be observed again and again, even though the golden rule of the stock exchange contradicts: "Let profits run sensibly and limit losses wisely". You don't have to be a financial genius to see that this is the exact opposite of what you should actually do.

The reasons for this irrational behaviour are complex. One explanation is that many believe in a return of the fallen stocks and continue to do so even when all the fundamental data and calculations of technical analysis argue against it.

In order to protect yourself from the disposition effect, the first thing you should do is to have an elaborated trading plan that takes a reasonable money risk into account. It is also advisable to limit losses consistently by maintaining stop-loss rates. Even if it is