This article appeared in the July 2010 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Gary Stone, Share Wealth Systems
Financial markets have ups and downs, sometimes extreme, which cause investors to experience emotional rollercoaster rides in line with price swings. Those who have lost money in the past few years may find it hard to deal with investment emotions, but controlling them is the key to successful investing and trading.
As information that affects financial market prices has become more rapidly and readily available, the volatility of the ups and downs has increased, along with the emotional swings of market traders and investors.
You have probably heard that successful trading starts with having an investment plan that includes a strategy or systemised approach with which to engage the market. A plan is certainly a necessary first step, but that alone is unlikely to achieve the investing outcomes you desire.
This is where the emotions of trading affect every investor. Our emotions almost force us to deviate from a predetermined plan. Unless you learn to control emotional reactions, you will make decisions that will be seen as logical but in reality are not.
The importance of controlling emotions
Although positive emotions, such as euphoria and over-joy, can negatively affect your trading, it is the negative emotions you really need to watch out for.
Take the saying 'Anger makes you stupid'. Being angry is one emotion that potentially can hijack the way you approach trading decisions. There are countless others, such as frustration, grief, envy, trauma, stress, rage, paranoia, hatefulness, betrayal and revenge that affect your state of mind and inevitably the decisions made in the heat of the market.
Medically this state is known as an 'amygdala hijack', when the amygdala bypasses the neocortex (the thinking part of the brain) and there is little or no ability to rely on intelligence, logic or reasoning. The effect is that mental energy is drawn exclusively into the hijack.
The immediate result of a hijack is a decrease in working memory. Adrenaline is released and will be present and effective for about 18 minutes, and other hormones are released into the bloodstream that will take three to four hours to clear. Their purpose is to deal with physical threat through the well-documented 'fight or flight' response. While in this state, people make illogical and irrational decisions - sometimes including buying or selling shares.
The unfortunate element of an amygdala hijack state of mind is you are unaware of it until afterwards and the damage is done. You will only become aware when you question the irrational investment decisions, and without the knowledge explained here, you will never know or understand why you made such poor decisions.
It's difficult to act as you 'should'
Being aware of how you need to think and feel, and how you 'should' act is simple and logical enough in theory. Actually accomplishing that in the heat of market conditions is very difficult for the majority of active investors.
To be successful in the market over the long term you need to acquire certain mental skills. You need to add new beliefs into your subconscious mind that automatically determine your perceptions, expectations, behaviour and emotional state in regard to engaging the markets. You also have to 'turn off' beliefs that can potentially sabotage your investing endeavours.
This is a transitionary process that requires desire to change and focus, to step into and complete the process. The transitional process is a whole topic on its own. Embarking on such a process will improve emotional responses to unexpected market outcomes, hence greatly improving the ability to execute a plan and lift investing performance.
The mental skills aim: consistency and objectivity
By achieving consistency and objectivity you will learn to control emotional responses and either avoid amygdala hijacks or learn to recover rapidly from them. The first step to achieving consistency and objectivity is to employ a strategy or systemised investing process that will remove the need to make subjective judgements, because a properly applied strategy will be consistent and objective to the criteria of the strategy. Your skills goal should be to remain consistent with your strategy's rules.
The suggestion that acquiring consistency and objectivity is an essential prerequisite for sustained profitable trading is certainly not new. Experienced traders and investors such as Mark Douglas, John Murphy, Martin Pring, Stan Weinstein, Joe Krutsinger, Jack Schwager, Jake Bernstein and Larry Williams have all written about it.
What are these two mental skills?
The dictionary definition of consistency is 'constant to the same thoughts and actions' or 'conforming to a regular pattern or style, unchanging'. The definition of objectivity is 'uninfluenced by personal emotion, prejudice, opinions or surmise' or 'having real existence outside of mind, not subjective'.
These take us into a world that is often vastly different from the one most people generally occupy. How often are our decisions and actions changed or swayed by other circumstances, interference, opinion or negative emotional responses?
Even for the most composed and tranquil of us, someone seen as the hypothetical 'model of consistency', it is not easy to maintain the same approach to all things 100 per cent of the time, especially in this increasingly fast-paced world with technology bombarding us with opinions, views and alternatives.
These skills are prerequisites to achieving financial outcomes. No matter how focused you are on goals you have set, you are unlikely to achieve them without the ability to consistently complete error-free trading processes and execution, unaffected by emotional outbursts that trigger an amygdala hijack state of mind.
And here is a vital point: while consistency and objectivity can be measured by the physical actions you take, they are actually mental skills manifested through execution of trades.
About the author
Gary Stone is the founder and lead research analyst of the 15-year-old business Share Wealth Systems. To understand the fundamental principles behind Share Wealth Systems' techniques and systems, you can watch an online video, How to Grow and Protect your Capital in the Market.
The ASX website has a wealth of free education material on charting. Visit the ASX Charting library to find stories that suit beginners through to advanced technical analysts. The ASX technical analysis course is especially useful for those who want to learn charting basics.
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