Monday, November 25, 2013

Three Common Psychological Mistakes Traders Make, and How to Overcome Them

The only technical news fit to print since Friday's update is the S&P 500's (SPX) new all-time-highs, which have officially validated my preferred Elliott Wave count of the past couple weeks.  There's been no material change in the market outlook for a while, and there are only so many ways I can say "the projections still look good" -- so today we're going to explore three common psychological mistakes which can derail traders (or anyone, frankly), and some strategies to overcome those mistakes.

Emotions in general are the enemy of traders, but certain emotions can be particularly damaging because they start us down a long path which ultimately ends in self-defeat.  Much trading advice has been written about greed and fear and similar emotions -- so I'm going to cover a more subtle topic: the emotion known (rather generally) as "discouragement."

Discouragement rarely hits us all at once, but tends to build over time in response to an ongoing series of setbacks and/or failures.  As negative events pile one on top of another, we may gradually become discouraged with our own efforts.  This feels like a "natural" response to the situation, so we often fail to recognize the immediate danger we're putting ourselves in:  Discouragement feeds on itself and can easily become a self-fulfilling prophecy. Negative events beget discouragement; discouragement begets reduced effort; reduced effort invites failure -- and failure begets even more discouragement... rinse and repeat.

If not halted quickly, we can gradually spiral downwards into a dark trap of our own making. 

In trading, this series of negative events often takes the form of a string of losing trades.  With no big winners to break the cycle, we feel increasingly frustrated and ineffective as we watch our accounts dwindle.  During these cycles, sometimes even the winning trades can make things worse for us emotionally.  If you've traded even moderately, you will know exactly what I'm talking about when I say that during these "losing trade cycles," it seems we always manage to close the winners for negligible profits only minutes before the market explodes in the direction we were hoping all along.  I believe this is unlikely to be coincidental, and may actually be a result of our own mindset -- part of the "self-fulfilling prophecy" of discouragement.

I imagine virtually everyone has encountered this type of setback cycle at least once (probably more than once) in their lives and trading careers.

Ultimately, discouragement is an internal response to external events.  And that's good news -- because while we cannot control the market or life itself, we can control our reactions to both. In fact, sometimes our only weapon against forces larger than ourselves is the freedom to choose our own reactions.  Granted, sometimes choosing positive reactions to negative events is easier said than done, especially when life seems to be kicking us while we're down.  Life is difficult.

But it's critical to keep these negative emotions in check, because even moderate discouragement can and will create a self-fulfilling pattern of failure if not halted immediately.  

So let's discuss some of the psychological pitfalls that lead to (and at the same time embody) discouragement -- and how we can overcome them:

Pitfall #1:  Being overly harsh with ourselves when we're already beat-up:

One of the worst things we can do to ourselves is to become overly harsh and endlessly self-critical at moments when our self-esteem is already suffering.  Sometimes we speak to ourselves in ways we would never even consider speaking to another person, and this negative self-talk can be extremely damaging to us (just as it would be if we were speaking to someone else!).  We sometimes justify this talk by telling ourselves it's a form of "tough love," and that we're using this harshness as motivation to improve -- but harsh self-talk doesn't motivate us when we're already wounded; all it does is discourage us even more.

If you just made a losing trade, beating yourself up afterwards simply doesn't help.

When our self-esteem is injured, the best way to position ourselves for future success is to nurture that esteem back to good health by focusing on the positive things we know to be true about ourselves -- not to crush ourselves even further with negative self-talk.   (Not surprisingly, the same is true when we're speaking to others whose self-esteem is suffering.)

Pitfall #2:  "You can't fire me -- I quit!" syndrome:

Another common mistake is to quit an effort before the battle is truly lost.  This is a self-defense mechanism -- it's a way to give ourselves the illusion of control by voluntarily giving up before we are (we assume) involuntarily defeated.  This one may be the toughest of the three pitfalls, because there are times it is absolutely correct to give up -- so we have to understand both ourselves and the situation to recognize when surrender is the correct course, and when it's an emotional cop-out.  Many times, we're quitting not because the situation is actually lost, but because we're discouraged and tired of the struggle. 

The average millionaire has gone bankrupt more than 3 times in his or her lifetime.  What separates those folks from the rest of the pack isn't luck, but the internal perseverance to pick themselves up and try again even after repeated failure.

The second reason this pitfall is challenging is because we frequently offer compelling excuses as to why quitting is the right move, and eventually convince ourselves that we're "just being realistic."  We tell ourselves that, gosh-darn-it, we tried our best -- but in the end, we just couldn't cut the mustard and that's okay, it just wasn't meant to be, blahblahblah.  There is a short-lived sense of relief that comes with giving up, as the pressure is suddenly lifted.  But it goes without saying that in order to reach one's full potential and discover what one is truly capable of, then one has no choice but to push oneself beyond the limits already known, comfortable, and familiar. 

If your goal is to go from being a losing trader to a profitable trader, then the only way to achieve that is to apply techniques you are not currently using.  Those techniques will initially seem foreign, unnatural, and uncomfortable.

People are inherently goal-driven; without goals to strive toward, our spirits gradually begin to atrophy just as an unused muscle would.  Pushing our own limitations makes us stronger.

(continued, next page)  

I believe there are very few things in life we cannot achieve if we genuinely apply every last ounce of personal effort and willpower.  If you've never seen the movie Men of Honor, which is based on the true story of US Navy Master Chief Carl Brashear, then I'd highly recommend it as an example of a man overcoming the odds and striving to live his full potential.  In addition to becoming the Navy's first African-American master diver, Carl Brashear also overcame a leg amputation and became the very first amputee to be (re)certified as a Navy diver.  Both were prolonged struggles, and he certainly could have made pretty compelling arguments to quit upon encountering either obstacle.  I think we can all agree that after his leg was amputated, giving up would have been "only realistic."

Instead, though, he chose to keep pushing his own internal and external boundaries -- and he ultimately achieved his goals through sheer willpower and hard work.  He may have been missing a leg externally, but his inner world was rich and complete.  Carl Brashear's successes would have been impossible without the internal support of his personal "never quit" philosophy, which is revealed by one of his quotes:  "It's not a sin to get knocked down; it's a sin to stay down."  

I think one other key to this pitfall is to surrender our emotional attachment to the end result, while still continuing to strive toward the goal in a disciplined and principled way.

Pitfall #3:  Giving quarter to ongoing self-indulgent rumination:

While it's critical to reflect on our mistakes, the only point of doing so is to learn the lessons those mistakes provide.  Once we learn the lessons, then it's time to move on.  But sometimes when life hits us with a big emotional blow, we fall into the self-indulgent trap of endless rumination.

Let's draw an example, and say we just exited a losing trade where we committed not one, but two large mistakes: 

1. We entered the trade based on emotion and chased into a high-risk entry. 
2.  We committed too much of our capital on the position.

As a result of these two mistakes, we just lost 50% of our account in one fell swoop, and we're not in a good place emotionally at the moment (in fact, we spend a lot of time feeling sick to the stomach).  We sit down and try to figure out what went wrong -- and eventually, eureka! we recognize our mistakes.  Then we do some more thinking, and we determine ways to avoid those mistakes in the future.  Stop!  At that point, our work is done and it's time to move forward with those newly-found insights.  But few of us can drop the heavy feelings on a dime... so often, we don't simply move on.  We just keep rehashing and rehashing, "Man, if only I hadn't done that!  I can't believe I lost eight gazillion dollars.  That was my early retirement!  I could have been in Barbados.  So much of my account wasted..." etc.

This is another wrong turn which ultimately leads us closer to self-defeat.  Instead of taking the lesson and moving forward into the bright new future, we are instead dragging the past around with us in discouragement.  It's as if we stepped in a big pile of dog-doo while strolling down the Path of Life, but instead of simply wiping it off our shoes and continuing on our way, we've decided to leave it on as a permanent, unpleasant reminder of our misstep.  "There, ya' smell THAT?  That's who I am!  Take a good long whiff, 'cause this is what I'm all about."

There is nothing to be gained from that type of thinking.

Take the lessons with you -- but leave the mistakes behind.

And as always: Trade safe.

Follow me on Twitter while I try to figure out exactly how to make practical use of Twitter:
Reprinted by permission; Copyright 2013 Minyanville Media, Inc.