Investors and traders enter financial markets with the firm belief that they will succeed. While many investors achieve success and meet their investment goals, less than 10% of traders consistently profit from trading. Such a difference is attributed to various approaches to market work. However, the failure rate among market participants is extremely high, with one of the main reasons being the numerous psychological traps in trading and investing, falling into which results in colossal losses.
From this article you you will learn:
- Psychological traps such as groupthink, loss aversion, and similarity bias significantly influence trading decisions, leading to suboptimal outcomes for investors.
- The tendency to conform to group opinions or avoid risks often overrides rational analysis, resulting in missed opportunities or unnecessary losses in trading and investment.
- Awareness of these psychological traps and the ability to control emotions are essential for investors to make informed decisions and achieve long-term profitability in financial markets.
Some Psychological Traps Traders and Investors Fall Into
The main reason for failures in financial markets is by no means the lack of experience and knowledge among investors, nor the inability to create or use a good strategy and trading system. Many lose their entire investment capital or a part of it, even when their system generates perfect signals, and the rules of money management and risk management are clearly and comprehensively formulated.
Losses are incurred due to emotional interference and problems with maintaining trading discipline. Often, they result from traders falling into psychological traps. Among the most common are the following.
Confirmation Bias
This effect manifests as a tendency to seek and interpret information in a way that confirms existing beliefs. A trader doesn’t necessarily have to be certain of their infallibility. It’s enough that they have formed a certain opinion over time, such as about the behavior of a chosen asset.
For example, an investor has long held shares in Company XXX and has made a decent profit from these investments. Such results create a stereotype that these securities will continue to rise. Consequently, even when analyzing new information about the company or its reports, the investor will primarily seek data and facts that confirm their opinion. Even if such an analysis yields information indicating a high probability of a negative scenario or casts doubt on their own forecasts, it will likely be ignored.
Thus, incoming data is viewed subjectively, through the lens of personal beliefs. The most unpleasant aspect of this is the ignoring of facts that contradict them. The significance of information is overestimated, leading to erroneous decisions and, naturally, losses.
Illusion of Control
Trapped in the illusion of control, a trader believes they have greater control over the situation than they actually do. For example, they are convinced that their trading system generates entry signals with an accuracy close to 100%. As a result, even in a changing market environment, they use these signals to make trades, feeling safe. However, they overlook that:
- The market is unpredictable;
- Results obtained in the past are not a guarantee of similar results in the present and future;
- A changed market environment requires at least a retesting of the trading system, often necessitating its reconfiguration.
As a result, the decision to enter the market turns out to be erroneous, and the trade, which was supposed to yield a positive result, ends in a loss. By remaining in this trap, traders risk not occasional, but systematic losses, which can quickly deplete their investment capital.
Loss-Aversion Effect
The loss-aversion effect manifests as the tendency of an investor to react more strongly to potential losses than potential gains.
One of the most vivid illustrations of this trap is holding onto losing positions (aversion to losses). It may seem straightforward to timely “reverse” a position (closing a losing trade at a minimal loss and opening another one in the opposite direction, potentially leading to profits). However, psychologists working with traders and investors provide statistical data indicating that almost 75% of traders are unable to make such decisions.
Another example is investors selling growing stocks at the first signs of a correction, even when there are no indications of a market reversal. Once again, virtual losses after reaching a local maximum become more important to the trader than the potential profit from further growth.
The second case is milder – trades end only with unrealized profits. However, in the first case, if the situation worsens further, it leads to even greater losses.
Similarity Effect
This term denotes the tendency to trust situations that resemble those in which a trader has previously had successful experiences, even if they are not directly related to the current situation. This can lead to risky decisions based on past positive results, rather than careful analysis of the current situation.
A simple example: an investor previously bought shares of Company XXX after a quarterly report showed a 1.5% profit growth. These stocks yielded him an annual return of 8%. When a similar report is released in the current situation, he is highly likely to repeat the purchase without analyzing the situation. However, changes in the economy and the market over time may be so significant that the reported 1.5% profit growth indicates serious flaws in the issuer’s operations. As a result, the trade has a high chance of resulting in a loss rather than a profit.
The similarity effect is one of the most common traps for market participants. After all, both technical and chart analysis are based on the principles of seeking patterns or combinations of indicators that previously formed a profitable signal.
To avoid becoming a victim of this effect, traders should remember that past profits do not guarantee the same result in the future. That’s precisely why professional market participants add this phrase to all risk notifications, to mitigate losses from the similarity effect.
Groupthink Effect
The groupthink effect manifests as the tendency to make decisions in line with the group’s opinion, even if it does not correspond to reality. This trap has been ingrained in humans for over millennia. Typically, when individuals doubt their actions in the current situation, they tend to compare their further actions with those of others. The latter are rarely objective, often based on emotions, and to some extent on the ability of leaders to impose their opinion.
As a result, the necessary market analysis is replaced by the emotional pressure of the “crowd,” which often leads to negative outcomes.
When a group acts truly consciously, the groupthink effect can yield positive results. An example of this is the case with GameStop stocks, where the union of a large number of retail traders managed to resist even major players in the stock market. Among the participants of this union, only a limited number of initiators acted consciously, while the majority joined driven by the groupthink effect, which did not prevent them from making a profit.
A specific manifestation of the groupthink effect is the so-called authority effect. In this case, the trader does not follow the group’s opinion but relies on the judgment of someone they consider a leader and authority. Thanks to manifestations of this effect, many investors use analysts’ conclusions and investment advisors’ recommendations in trading. Unfortunately, the effectiveness of such an approach is not very high; otherwise, there would be no losing trades in the market (nor the market itself).
Loss-Aversion Effect
This trap appears as traders’ tendency to avoid risks, leading to conservative decision-making. Although this approach rarely results in direct losses, the foregone profit can be extremely high. The price for such indecision becomes delayed achievement of investment goals or the complete inability to realize plans.
Usually, this effect develops against the backdrop of significant losses in previous trades. The trader believes they can make things right by being cautious. As a result, the level of risk in future trading significantly decreases, but so does the profitability of investments.
Overall, all these psychological traps result from investors’ inability to counteract their own fear and greed. By controlling emotions, negative effects will occur much less frequently, and trading and investments will truly become profitable activities.