Four Fears of Trading

05/28/2004 12:00 am EST

Focus:

Price Headley

Founder and Chief Analyst, BigTrends.com

Although geared primarily to traders, this sage advice from Price Headley, chief analyst for BigTrends , applies to both traders and investors alike. Here, he looks at the psychology of investing and addresses the four fears that impact our investment decisions.

"While most traders and investors place their focus on the next hot stock or sector, I find that the mental state typically is more important in determining the ultimate level of success that can be achieved. And the biggest aspect of the psychological game of investing is learning how to manage your fears. The reality is that all traders and investors feel fear at some level, but the key is how we prepare to address our concerns related to taking on risk in the markets. I would like to review four major ‘fears’ experienced by traders and investors, and how these fears create undesirable behaviors. Basically, my aim is to have you walk away with an understanding of these dangers so you can implement strategies that will address your fears and let you get on with your investment plan. All traders and investors have fear, but winners manage their fear while losers are controlled by it. Here are the four major fears in trading and investing, and how you can work to handle them:

1. Fear of Loss

"The fear of losing when making a trade often has several consequences. Fear of loss tends to make a trader hesitant to execute his trading plan. Fear can set in place a vicious cycle of recurring doubt and, in turn, reinforce a traders' lack of confidence in executing new positions. Thus begins the analysis paralysis, where you are merely looking at new trades but not getting the proper reinforcement to pull the trigger. In fact, the reinforcement is negative and actually pulls you away from making a move. I believe the root stems from a lack of confidence about the trading plan, which then causes the trader to believe that by not trading, he is moving away from potential pain as opposed to moving toward future gain. No one likes losses, but the reality is, of course, that even the best professionals will lose. The key is that they will lose much less, which allows them to remain in the game both financially and psychologically. When you're having trouble pulling the trigger, realize that you are worrying too much about results and are not focused on your execution process. Make sure your have a written plan and then practice executing your plan. You should be more concerned about avoiding big losses and less concerned about taking small losses. If you can't bear to take a small loss, you will never give yourself an opportunity to be around when a big winning idea comes along. And never get stuck in the mindset of hoping a loser will come back. In most cases, that leads to even greater losses.

2. Fear of Missing Out

"Every trend always has its doubters, but I often notice that many skeptics of a trend will slowly become converts due to the fear of missing out on profits or the pain of losses in betting against that trend. The fear of missing out can also be characterized as greed of a sorts, for an investor is not acting based on some desire to own the security other than the fact that it is going up without him on board. This fear is often fueled during runaway booms like the technology bubble of the late-1990s, as investors heard their friends talking about newfound riches. The fear of missing out came into play for those who wanted to experience the same type of euphoria. This is a very dangerous situation, as at this stage investors tend essentially to say, ‘Get me in at any price.’ The effect of the fear of missing out is a blindness to any potential downside risk. We remember the stories of the Internet and how it would revolutionize the way business was done. While the Internet has indeed had a significant impact on our lives, the hype and frenzy for these stocks ramped up supply of every possible technology stock that could be brought public and created a situation where the incredibly high expectations could not possibly be met in reality. It is expectation gaps like this that often create serious risks for those who have piled into a trend late, once it has been widely broadcast in the media to all investors.

3. Fear of Letting a Profit Turn into a Loss

"Most traders do the opposite of the "let profits run, cut losses short" motto: they instead like to take quick profits while letting losers get out of control. Why would a trader do this? Too many traders tend to equate their net worth with their self-worth. They want to lock in a quick profit to guarantee that they feel like a winner. How should you take profits? Should you utilize a fixed target profit objective, or should you only trail your stop on a winning trade until the trend breaks? Those who can accept more risk should consider trailing a stop on their trending position, while more conservative traders may be more comfortable taking profits at their target objective. There is another alternative as well, which is to merge the two concepts by taking some profits off the table while seeking to ride the trend with a trailing stop on the remaining portion of the position. I'm also a big fan of moving your stop up to breakeven relatively quickly once the position starts to move in your favor.

4. Fear of Not Being Right

"Too many traders care too much about being proven right in their analysis on each trade. To be successful, you must trade without ego at all costs. Ego leads to equating the trader's net worth with his self-worth, which results in the desire to take winners too quickly and sit on losers. If you have a perfectionist mentality when trading, you are really setting yourself up for failure, because it is a given that you will experience losses along the way in trading. The objective should be excellence in trading, not perfection. In addition, you should strive for excellence over a sustained period, as opposed to judging that each trade must be excellent. The great traders make mistakes too, but they are able to keep the impact of those mistakes small, while really riding their best ideas fully. You must acknowledge the risk and use a stop on every trade to admit when the analysis is no longer timely. Trading without stops is an ego-driven approach that hopes to avoid accountability for a losing trading idea. This is an unacceptable behavior to the successful trader, who knows he must limit risk with stops to stay in the game for the next trading opportunity.

"In summary, your trading plan must account for the emotions you will be prone to experience, particularly those related to managing fear. As a trader, you must move from a fearful mindset to mental state of confidence. You have to believe in your ability as well as the effectiveness of your plan to take profits that are larger than the manageable losses. This builds the confidence of knowing that you are on the right track. It also makes it easier to continue to execute new trades after a string of losing positions. Psychologically, that's the critical point where many individuals will pull the plug, because they are too reactive to emotions as opposed to the longer-term mechanics of their plan.

"Too many investors have an ‘all-or-none’ mentality. They're either going to get rich quick or blow out trying. You want to take the opposite mentality one that signals that you are in this for the longer haul. This gives you ‘permission’ to slowly get comfortable and to keep refining your plan as you go. As you focus on execution while managing fear, you realize that giving up is the only way you can truly lose. You will win as you conquer the four major fears, to gain confidence in your trading method and, ultimately, you will gain even more confidence in yourself."

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