Psychology and Emotions in Investing

TL;DR: Investors often make mistakes because of emotion and thinking errors, not lack of knowledge. Fear, greed and the urge to confirm what you believe steer your choices. You cannot switch them off, but you can use rules, checklists and a journal to decide more calmly.

Step-by-step guide

1. Write down your plan before you trade: entry, exit, maximum loss.
2. Decide your position size in advance, so a loss does not send you into a panic.
3. Use a checklist before every trade: am I following my plan, or reacting to emotion?
4. Keep a journal of your trades and how you felt.
5. Set a limit per day and per week, and stop when you reach it.
6. Take a break after a series of losses before carrying on.
7. Deliberately look for arguments against your opinion.
8. Review weekly and adjust your rules if you see a pattern.

Why emotions play a role

Money affects us. A loss often feels more painful than an equal gain feels pleasant. As a result, investors regularly make the same mistakes: they hold losers too long hoping the price will come back, and take profit too early for fear of losing it again. This happens to experienced investors too.

Fear and greed

Fear makes you sell too early, or not dare to enter. Greed makes you take too much risk or chase a rising price. Both lead to decisions you would not make in a calm moment.

FOMO

FOMO (fear of missing out) is the fear of missing something. You see a price rising, everyone is talking about it, and you buy because you do not want to be left out. Usually you then buy after a big rise. Ask yourself: does this fit my plan, or am I buying out of fear of missing out?

Common thinking errors

Loss aversion

Loss feels heavier than gain. Result: you stay in a losing position hoping for recovery, and take profit quickly. A stop-loss decided in advance helps, because the decision has already been made before the emotion starts. Keep in mind that a stop-loss is not always executed at the level you want.

Confirmation bias

You look for information that fits your opinion. If you own a share, you mostly read positive news. So also deliberately look for the best arguments against your position.

Recency bias (latest experiences weigh too heavily)

A few good trades in a row make you overconfident, a few losses make you anxious. A small series says little about the quality of your approach. Look at a large series of trades, not the last five.

Revenge trading (winning the loss back)

After a loss you want to win it back immediately. You take a bigger position or trade outside your plan. An example: your account is €10,000 and you lose €100 (1%). You then double your position, so you risk €200 on the next trade. A second loss makes the hole bigger, and the emotion too. A fixed rule prevents this: after a loss you do not carry on without a break.

Market mood is not a reliable signal

You sometimes see statements that you should trade against the crowd: buy at panic, sell at euphoria. But panic can go further and euphoria can last a long time. Sentiment indicators, such as the volatility index (VIX) or a put/call ratio, give a picture of the mood, but not a reliable buy or sell signal. At most, use them as background.

Rules that help

Willpower works badly under stress. Fixed rules work better, because you have set them before the emotion.

A checklist before every trade

Answer in advance:

1. Does this trade fit my written plan?
2. Do I know where I will exit, both at a loss and at a profit?
3. Have I calculated my position size, for example with the position size calculator?
4. Am I trading out of emotion, such as FOMO or anger?
5. Can I bear the loss without it affecting my finances or my sleep?

If you cannot answer yes to all questions, you skip the trade.

A limit per day and per week

Choose a limit in advance. For example, with an account of €10,000: stop for the day if you have lost 2% (€200). Also decide how long a break you take after a series of losses.

A worked example: a series of losses

Suppose you risk 1% of your account per trade. Your account is €10,000. After 5 losses in a row your account is €10,000 × 0.99⁵ = about €9,510, a fall of about 4.9%. After 10 losses in a row it is about €9,044, about 9.6% lower. That is unpleasant, but bearable. If you risk 10% per trade, your account has fallen 41% after 5 losses and 65% after 10. So a smaller stake makes a losing streak easier to bear, and with it your emotions. See what a fall means for recovery with the drawdown calculator and read more about risk management.

A journal

Note for each trade what you did, why, what the result was and how you felt. Look back weekly for patterns: do you lose more often after a missed plan, on tired days or after anger? See also the trading journal.

Investing in stocks and emotion

Anyone who invests in stocks sees prices swing sharply at times. That is normal and not a reason to sell. If you know in advance how much swing you can handle, you do not need to panic in a turbulent period. Spreading across several investments helps too.

Investing and trading involve risk: you can lose all or part of your money. Past performance is no guarantee of future results. This tutorial is information, not investment advice.