Learn about a few simple concepts that can help you avoid emotional traps in trading. By JON OSSOFF No matter what style of trading we practice, we bring with us unique personalities and life experiences that shape who we are and how we perceive the world. These elements in turn color our relationship to the market: how we observe it, how we evaluate it and, as a result, how we trade it. The way we label and perceive events (and especially our own emotions) dictates our trading. Much of our perception and action is shaped by something psychologists call “generalization” — how we take what we learn in one situation and apply it to other situations. For the most part, this is a good thing. For example, if you are computer literate on a Gateway, you will also be computer literate on a Dell. Or, the fact that your old love disliked your roving eye will allow you to intuit your new love dislikes it just as much. The problem with generalization is that patterns of behavior or emotion that may work very well in other aspects of our life often fail miserably in trading. Why? Because active trading demands we cut our ties to past conditioning and focus on the present, while generalization brings up prior models of conditioned behavior and emotions. For example, we continually hear about how greed and fear impact the market and the detrimental effects they can have on an individual’s trading. But is this necessarily the case? It depends on how you perceive the market. The multitude of traders, institutions and hedge funds interacting in the market constitute a collective herd ruled by group dynamics. On a broad scale, traders enter and remain in positions out of greed (to gain more profits) and exit positions out of fear (to lock in gains or to protect capital). Because groups are by nature more primitive than the individuals who comprise them, a macroeconomic view of the market as an exotic bazaar where greed and fear proliferate makes perfect sense. However, each of us is ruled by subjective beliefs that preclude a purely collective market interpretation. Thus, generalizing from the macroeconomic to the intrapersonal represents distorted thinking and can trap us in poor trading behavior. The multitude of traders, institutions and hedge funds interacting in the market constitute a collective herd ruled by group dynamics. But, each of us is controlled by beliefs that preclude collective market interpretation. Greed, fear and attachment Greed and fear are the commonly referenced twin enemies of trading. But what many traders assume is simple greed or fear — the overwhelming desire to make more money or the fear of losing it all — is often something else: psychological attachment. This attachment is frequently driven by considerations other than money. For example, a trader might not sell a position in a particular stock because it may have been the first stock in which he or she made money; or it may represent the market when trading was simple and profitable. (It may even remind you of the person you were dating when you bought it.) There are many reasons we hold on to positions. Why do we “hold on” to anything? For security. For protection. We hold on because there is the fear of letting go. We think, “If I get rid of this stock, what do I do then? Do I stay in cash? Do I buy something else? If I buy something else, I might end up with less than I have now. That would mean I would have to face the fact I’ve made two mistakes, not just one. So I’ll just keep things the way they are.” Fear of change results in strong emotional responses, and emotions are unequivocally a poor foundation on which to base trading decisions. As an example of this, consider the situation of an investor, Jim, who owned Lucent Technologies (LU) at virtually no cost basis when it spun off from AT&T (T) in 1996. He rode the stock up to a high of 83.75 in December 1999, then proceeded to watch in revulsion as it came back to earth. He was up about $90,000, then $80,000, $60,000 etc. As it declined, he continued to give the proverbial reply “It will come back.” Sound familiar? As a stock makes new highs there will be ample evidence that greed has taken over. In our heads we plan our futures, pay off our mortgages, buy a new car. And with each of these pleasant reveries (“paper-profit fantasies”) we become increasingly enamored of this thing that is going to emancipate us financially. The mind believes the “correct” price is the current high and attempts to will the price even higher. If the stock does go higher, we discard the most recent high and latch on to the new one, always readjusting our belief that the highest high is the “right price.” This experience is what fuels greed in the individual trader. Yet as a stock retraces its gains, it is attachment that reigns supreme. And this attachment is often something other than not wanting to take a loss and admit you were wrong about the trade. For days, or weeks, you’ve checked the stock in the paper or the Internet, and discussed it with friends — or worse — in chat rooms. It’s no longer simply a stock; it’s virtually a living, breathing entity with which you’re having a relationship. The irony is that as the stock price decreases, our attachment to it increases. Like a sick friend we want to nurse it back to health. Meanwhile we are too wrapped up in the emotional hazard to recognize reality. Although the active trader may hold a position for no more than two or three minutes at a time, he or she is just as susceptible to attachment as a longer-term trader or investor. The time frame may change, but the psychology of attachment remains. For example, you may have traded a stock 50 times with good results. As the trades become less profitable and worthwhile, you rely on the past and unconsciously assess the stock’s strength predicated on what it did then, not what it is doing now. You may be glancing at a stock quote on your screen at 36.375, but you may be reacting as you did when it was 136.375. Learned helplessness Let’s get back to Jim. As the stock continues to drop, a second psychological process manifests itself — a process that, paired with attachment, makes it virtually impossible to avoid huge losses and market miscues. It is called “learned helplessness.” About 35 years ago, researchers conducted an experiment in which they electrically shocked dogs when they attempted to leave their cages. Later, the dogs were provided with an escape route, but chose to remain in their cages even in the face of continued shocks. Evidently, they had learned they were “helpless” even though they could have fled their enclosures. This phenomenon manifests itself in human beings in countless settings where negative experiences have shaped behavior. What is intriguing about this theory is that non-control alone is not sufficient for learned helplessness to occur. A person must come to expect the outcome as inevitable. It’s impossible to divine why Jim fell victim to learned helplessness. However, we can surmise that experiences of feeling little or no control, either in the market or in other areas of his life, had generalized to this situation, making it virtually impossible for him to act rationally as his position melted down. Some of Jim’s comments during LU’s fall into oblivion were revealing. On Jan. 6, 2000, when the stock fell $20 from 72 to 52 on earnings warnings: “I knew I should have sold before.” (Had he sold that day, he still would have made more than $60,000.) Between May 25 and June 5, 2000, when the stock rallied from 50 to 65: “I’m gonna hold it. It will come back to 80. Then I’ll sell.” Emotions can never be completely eliminated from trading, but by cultivating an awareness of patterns that impact our trading, the better we will manage that emotional edge. Fall 2000 to spring 2001, as Lucent fell to 14: “There’s nothing I can do. If I sell it will go higher. If I hold it might come back. I should have done something before. I knew I should have sold before.” Such thoughts are typical of many traders whose stocks plummet. They feel paralyzed and incapacitated — a classic symptom of being in the grasp of learned helplessness. They become immobilized and incapable of making decisions and, as a result, their profits shrink to naught. It is important to realize that emotions can never be completely eliminated from trading. However, the more awareness we cultivate and the more aware we are of patterns that may impact our trading, the better we will manage that emotional edge. Taking action Acknowledging these problems is one thing; doing something about them is another. What steps can traders take to combat these issues? Although behavioral change is not the only means to greater trading success, it is assuredly part of the solution.