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Now and then when I'm reading an article from the world of behavioral economics discussing a particular phenomenon, it makes you realize once again how much trading and investing is about human behavior.
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The trading world is known for its beautiful one-liners that are all so true, but at the same time so extremely difficult to practice. Some of the most well known around are: "Cut your losses and let your profits run." or "The trend is your friend." (until it isn't), just to mention a few. Collecting more of those one-liners would be a great subject for another article. This post deals with getting with the trend.
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Humans are very good at recognizing patterns in everyday life, and mostly patterns that we are familiar with. For instance, it doesn't take us a whole lot of effort to recognize a face, even if that face is showing a different expression than the first time we saw it. Recognizing a road crossing but from a different angle than the first time is equally easy.
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Investing in gold has been on every front page in the last two, three years. The financial crisis has scared a lot of investors who lost faith in everything but gold. Many investors buy gold in some form, in paper or physical gold. Investing in gold is not something from the last couple of years, but has been around for many years. It's just that the last couple of years, gold has every characteristic of being a bubble. Gold investors sometimes seem to lose all good sense of judgment and logic. Buying gold has almost become a sort of religion.
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It's been over a year now since we've witnessed the so-called flash crash. On May 6th, 2010, within minutes the markets dropped several percent, then bounced and recovered a large part of the losses. To relive those exciting moments, here are some video clips. If you know of any other clip that should be here, please send me an email. This post with video clips is mostly fun, but it's also showing us panic, anxiety, greed, and fear. Besides crash flash videos, there are some other clips that show the emotions that sometimes come with trading.
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We have all heard of the famous experiment by the Russian physiologist Ivan Pavlov where dogs have been conditioned to expect food following a particular event. The Pavlov dogs have experienced the same sequence of events so often, at some point they know what's coming next without really thinking about it. They start to show emotions 'in advance', and salivate even before their food is served. This is one form of conditioning.
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Many traders read all the news, rumors, and gossip they can get their hands on. And there's always more to read. Then they start convincing each other on chat forums that the market has to go in a certain direction based on that news. In the end, they all agree, but we know what happens with crowd consensus.... it's not going to happen.
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In this article, I would like to discuss the subject of overconfidence. Maybe in some way, overconfidence can be looked at as the exact opposite of perfectionism. Neither emotions serve a trader well as they do not take the market (movement) for what it really is.
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Some say in trading the true character of a person comes forward with all its strengths and weaknesses. Suppose a trader tends to be perfect, to perform every little task in perfection. For people with perfectionism, it may not be that hard to function in everyday life, maybe with a little struggle here and there. But it's very hard to combine perfectionism with trading.
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If you have a losing trade that was stopped out, and maybe a string of losing trades, this might upset and frustrate you as a trader. You start to wonder how you ended up on the wrong side of the market each and every time.
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As some of the regular visitors probably know, I am a great fan of Dr. Brett N. Steenbarger. I remember reading one of his articles where he discussed the problem of being addicted to trading. To illustrate this, he showed a list of questions that were normally used to determine whether someone was addicted to alcohol.
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Before taking a trade, you should have done your analysis. If the analysis shows that the trade has a high probability of being successful, you enter it and see what happens. Now suppose the market moves away and your position is getting worse. No real problem, there is never any guarantee the analysis will work.
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When I think about trading rules, the first thing that comes to mind in less than 0,047 seconds is: always to use a stop loss. Everyone knows this saying 'Cut your losses and let your profits run'. That is, of course, easier said than done and this article is not about that. This article is essentially about accepting a loss.
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We like to think that humans make decisions in a rational and logical way like computers do. Most economists model the consumer as a rational being, a consumer that makes well-informed rational decisions.
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Everybody knows this feeling and also knows it is a false feeling. You're in a casino, and the roulette hits red. Then again and again. After three, four maybe five times red in a row, you start to think it's time for the roulette to hit black. Now, in this simple case, you know that's not true.