human factors

Stockmarket psychology

Making money on the stockmarket should be easy. Simply buy stocks, shares or managed funds when prices are low and sell them when prices are higher. This is basic mathematics! However, if it is so easy, then why do so many people lose money? Several studies have shown that the typical private investor buys when stocks are high and sells them when they are low. This is not a strategy to make money.

In this article, I discuss how the principles of human factors can help ordinary retail investors to make money (or not lose money) on the global stockmarkets. Of course, this is general information for education only and I’m not providing financial advice.

Online broker - humanfactors101.com
In 2020, it is estimated that more than 10 million new trading accounts were opened in the United States.

During the COVID-19 pandemic, the number of people trading or investing on the stockmarket increased dramatically. The interest rates on savings accounts plummeted, huge populations found themselves at home with time on their hands and the prices of certain companies rose massively following the March 2020 dip. During this volatile period, the huge fluctuations in stock prices created opportunities for fortunes to be made (and lost). Spectacular gains in some stocks were shared widely on social and mainstream media.

These and other factors encouraged many people to open trading accounts. The major online brokers in the US (Charles Schwab, TD Ameritrade, Etrade and Robinhood) saw new accounts grow by as much as 170% in the first quarter of 2020.

A report by the Australian Securities and Investments Commission (ASIC) showed that over 140,000 Australian investors opened new trading accounts with brokers between 24 February and 3 April. Accounts were opened at a rate of 3.4 times compared with the previous six months. Additionally, a large number of accounts that had been dormant for the previous six months started to trade again during this period. That led to a huge amount of new money finding its way into global stockmarkets.

Over the ASIC focus period, there was a significant increase in the trading of complex and high-risk products (such as those that use gearing or lending, which can dramatically increase returns and loses). For some complex financial products, the losses can greatly exceed the initial investment.

“The average daily securities market turnover by retail brokers increased from $1.6 billion in the benchmark period to $3.3 billion in the focus period”.

Australian Securities and Investments Commission (ASIC), May 2020

Many people are trading on the stockmarket using execution-only online brokers. The internet has made trading quick and easy. With little or no training and minimal research, people are making decisions that will have lasting impacts on their financial future.

How to lose money

Behavioural economics - humanfactors101.com
The study of how psychology influences our financial decisions is known as Behavioural Economics.

Many people lose money when trading or investing on the stockmarket. This is simply because we are human. We act on our emotions or instincts, and we are subject to cognitive biases (errors of thinking). These human factors can lead us to make poor decisions and lose money. Psychology plays a significant role in how well we perform on the stockmarket.

We can take a task analysis approach and breakdown stockmarket trading into discrete tasks, such as seeking and reviewing information; choosing products; and then buying, holding and selling products. Each of these high-level tasks could be broken down further into sub-tasks.

From a human reliability perspective, here are some of the potential human failures in stockmarket trading:

  • Making the initial decision to trade on the stockmarket (it’s not right for everyone)
  • Buying the wrong company, fund, sector or product
  • Buying at the wrong time
  • Selling something when we should be holding it for longer
  • Holding onto something when we should be selling
  • Investing too much money
  • Focusing on a particular industry or theme, ignoring the wider market.

I’ve listed below some of the behaviours that impact on investment decisions which help to explain the above human performance issues and why many investors lose money. These ‘cognitive biases’ or psychological pitfalls are systematic errors in thinking. Most of our daily behaviours are driven by behavioural habits and patterns; the same behaviours can influence financial decisions. These cognitive biases can lead to irrational decisions. Some of the following biases are more prevalent in the search for information, some in the selection and purchase phase of trading, others in the holding and selling phases.

Confirmation bias: This is perhaps the best-known cognitive bias. It refers to seeking only information that supports our views or decisions. Investors actively seek confirmation of their investment decisions and assumptions, whilst avoiding opinions and research that is contrary to their views or assumptions. Investors become satisfied with their decisions and do not seek alternatives. A related bias is information avoidance – investors have been shown to check their portfolios more often in rising markets, than when markets are falling.

Regret theory: When investors buy a stock that falls in value, they avoid selling in order to avoid the regret of having made an error of judgment. By not selling the stock (and showing a real loss), they can avoid dealing with the regret. However, if the stock is not sold and continues to fall, avoiding regret leads to more regret. Regret theory also applies when an investor watches a stock but doesn’t buy it, and it subsequently goes up in value. We regret losses in popular stocks less than losses in speculative stocks, as many other traders have also realised losses in the popular stock.

Anchoring: Investors make decisions on arbitrary reference points, such as basing trading decisions on the price that they previously paid for a stock. If a stock falls in value it is seen as ‘cheap’ or ‘on sale’. However, the value of a stock has no relation to the price that an individual investor previously paid. Anchoring causes investors to base decisions on their recent trading price, rather than on other data. Anchoring also occurs when traders are presented with information – if positive information on a company is presented first, investors are less likely to consider less-favourable information presented afterwards.

Framing: The way that information is presented to investors greatly influences their trading decisions. For example, investors may purchase a company that is reported to have a 30% probability of an annual return of over 5%. However, they would be less likely to invest if they had been told that the same company has a 70% probability of an annual return of less than 5%. Companies will often frame their results for the most positive ‘spin’, for example, only presenting the historical investment periods with the best performance, or choosing a certain scale on a chart that presents the results in the best light.

House money: Profits from stockmarket trading (known as house money) are seen as different from that money which is held in ordinary saving accounts. A form of mental accounting creates this distinction, and investors will place trading profits at greater risk than they would money from savings in the bank. A dollar from stockmarket gains is seen as having lower value than a dollar in the bank. This bias is also common when gambling.

Overconfidence: Despite little training or experience, many investors rate themselves as being above average in their trading abilities. Inexperienced traders often believe that they are better at ‘timing the market’ than anyone else – even when trading against more sophisticated investors, supercomputers and institutional investors. Overconfidence is amplified when the market (or a purchased stock) is rising. This leads to an underestimation of risks and an overestimation of expected gains.

Recency bias: Companies, products or market trends that were seen last are remembered more clearly; and those most frequently reported in the media will be remembered more quickly by investors. Investments are made in companies that are more widely known or easily recalled. This also applies to the financial markets in general – investors base decisions on recent market movements and may fail to learn from history.

Sunk cost fallacy: The tendency to hold onto a falling investment for fear of losing the initial investment. Traders may hold onto a failed investment that has no possibility of recovery rather than close the position by selling. They may also invest more, and throw good money after bad; hoping to recover the initial investment.

Loss aversion: Most people will fear losses more than they enjoy gains. Research shows that losses hurt us twice as much as profits make us happy. Selling at a profit makes us happy, but we avoid selling at a loss. Therefore, profits are realised too early in the stock’s trading pattern, and losses are sold too late. Loss aversion leads to inertia.

Home bias: Although online trading platforms have made investing in international markets easy, investors tend to trust local and familiar companies. Most investors tend to buy into companies from their home country (even if that country makes up a small percentage of the global stockmarkets). This bias prevents full diversification of investment choices.

Bandwagon effect (Herd behaviour): Herding involves following the crowd, and going with the flow, partly because investors fear making mistakes or missing opportunities. Fear Of Missing Out (FOMO) was almost certainly at play during the stockmarket recovery in 2020.

Endowment effect: We tend to value something higher if we already own it. This explains why investors refuse to sell a stock that is falling in value, but also admit that if they didn’t already hold it, they would not buy it at the lower price. Owning a stock means that people want to keep it.

Increasing your chances

These cognitive biases (or mind traps) are so powerful, partly because they operate at a subconscious level. They are mental reflexes, and just like physical reflexes, they are automatic. You may have heard of System 1 and System 2 thinking. Cognitive habits, assumptions and shortcuts operate at the System 1 level; which is instinctive, intuitive, fast thinking, taking place on autopilot with little effort.

In order to prevent these biases, we need to encourage thinking at a more conscious, slower pace. This System 2 style of thinking is more logical, critical, informed and reflective. It therefore requires more deliberation and effort.

Understanding how your emotions and biases impact on your trading can give you the edge.

The cognitive biases cannot be eliminated completely; however, there are steps that can be taken to mitigate them.

My high-level guidance would be:

  1. Set (and follow!) some simple trading rules and guidelines, rather than rely on your emotions.
  2. Document each trading decision and the basis for that decision (e.g. are you buying or selling purely on price, or based on company fundamentals, wider economics or technical analysis of charts etc?).
  3. Make your decisions, reasons and assumptions explicit – write them down before you execute a trade.
  4. Consider alternative options (or contradictory information) and write down the pros and cons of each.

Here’s a few more suggestions to increase your chances of success in trading decisions. They are designed to encourage the slower, more deliberate and analytical type of thinking (System 2). Hopefully, these tips will help to prevent trading on the stockmarket from feeling like a rollercoaster of emotions.

  • Document your trading or investment strategy – what are you investing for? When will you need to cash-in?
  • Maintain a trading diary and review this to identify opportunities to improve.
  • Consult your diary and investment strategy before you sell – if you previously documented the conditions that would trigger a future sell, have those conditions emerged?
  • Talk to family members or loved ones before making a trade – even if they have less information or experience than you, having the conversation helps to make your thinking process more explicit and conscious, rather than automatic and emotive.
Investment - trading - humanfactors101.com
Document and assess the assumptions that you are making for each trading decision (e.g. currency rates, commodity prices, future company activities or projects).
Trading analysis - humanfactors101.com
Critically assess glossy marketing brochures or websites. How do they present key information? What key information is not presented?
  • If you are trading with money in a trading account held with your broker; ask yourself whether you would make the same trade using money withdrawn from your savings account.
  • Seek counter-arguments to inform trading decisions; actively seek out news or research that contradicts your opinion, or the position that you plan to take.
  • If you are interested in a particular company or product, ask yourself how you came to think of this company – and is it the best use of investment funds at this time?
  • Look at statistics and probabilities in reverse. For example, if there is a 30% chance of something happening, is there a 70% chance that it won’t happen? When framed in the reverse, does it still appear as attractive?
  • When you buy a stock, decide on what price you would sell should it fall in value in the future (the ‘stop loss’ price) and then write this down, or program it into your trading software. The price that you set will depend on how volatile the stock is, your appetite for risk and investment timeframe. An automatic stop loss will remove emotion from the selling decision.
  • If a stock falls and you’re making a loss, ask yourself whether you would buy this stock at today’s prices. If the answer is no, then perhaps you should sell.
  • Review your portfolio to assess whether it is appropriately diversified. Have you inadvertently focused on a specific sector, industry or country?
  • Remember ‘risk versus reward’ – the rewards will be highlighted by the company, but do you understand the risks?
  • If you don’t understand a company or product, don’t buy it until you do. Can you explain to others why you should invest in the company, or how the financial product works?
Information - humanfactors101.com
Consider making key buy/sell decisions when the stockmarket is closed, to help manage emotions and reduce impulse trading.

Finally, don’t make significant financial decisions when you are tired, distracted, hungry, under the influence of medication or alcohol, or when highly emotional. These, and other Performance Influencing Factors, can limit your ability to make good decisions.

Homework / CPD

If you are studying psychology or human factors, or simply wish to understand these concepts further, here’s some exercises that you can complete. If you are a member of a professional institution in the areas of psychology, human factors or health and safety, these activities could contribute to your Continuing Professional Development (CPD).

  1. Identify a major decision in your life (such as a house, car or gadget purchase) and assess whether any of the above cognitive biases played a role in your decision. What have you learned from reviewing your decision and what might you do differently next time?
  2. Identify a company having a significant profile in the media recently. How might the cognitive biases contribute to that company’s share price? Have recent share price movements in that company been determined by national/global economics, company fundamentals, or investor psychology?
  3. Identify a prominent company that you are familiar with. Has that company been portrayed differently in social media, compared with the traditional media or the company’s own reports and accounts? How might these differences impact on investor psychology?
  4. Review the marketing brochure for a Managed Fund, Investment Trust or Licensed Investment Company. How has the company presented key performance information and could this encourage cognitive biases?
  5. Produce a Hierarchical Task Analysis (HTA) for trading on the stockmarket. Build on the high-level tasks provided (i.e. seeking and reviewing information; choosing products; and then buying, holding and selling products).
  6. For each of the sub-tasks that you identified for the high-level trading activities, identify potential human failures, potential cognitive biases and Performance Influencing Factors that might contribute to these failures.