Beating the market is not just about having a good strategy. It is even more important to have the emotional control and discipline to execute that strategy, consistently and with focus. Making money in the market is simple, but it is far from easy.
In my 30 years of trading, I have made countless mistakes repeatedly. Those mistakes almost always come down to not being a master over my emotions and biases that cause me to make bad trading decisions.
I have also taught others how to trade my strategies for over 20 years and have watched almost every student make those same mistakes. When you know what they are, they become obvious. However, the solutions are not always easy to find or execute. The reason is simple; it is hard to overcome being a normal human with a normal emotional attachment to money.
My experiences from the past 30 years of trading make me something of an expert on making mistakes. I believe that those who can overcome themselves will excel in trading the stock market. Those who cannot find their success rises and falls with the trends of the market.
To be a successful investor, you must overcome your emotions. Here are two ways to do that:
Do Not Chase Greed
In the short-term time horizon for the stock market, the fundamentals do not matter. Stocks can go up quickly because there are emotional buyers chasing after a fast moving upward trend. However, when the emotion wears off, these same stocks can come crashing down to earth quickly. If you are part of the crowd and coming into a strong stock late, you may be setting yourself up for failure.
There is a simple rule that will help you avoid chasing after greed.
Buy when the stock is breaking from low volatility, not after it has already been going up for a while.
Here is a chart that demonstrates this idea:
Throughout the recent stock market crash and recovery, I have been focused on buying stocks that had sold off sharply and then broke their downward trend line after building a rising bottom. Ideally, this comes with a break from low price volatility.
Low price volatility simply means that the stock is not moving up or down a lot in price. In the chart above, that occurred at point 1. You can see that the height of the candles on the chart are short indicating that the stock did not have a lot of price volatility.
Point 1 was also the rising bottom and at Point 2, there was the break from low price volatility. This was the signal that the stock was starting an upward trend and the ideal place to buy. Most investors would doubt this signal to buy because the recent market activity was a frightening sell off and most people will not buy in to fear because they feel it themselves.
People will start to feel the itch to buy at the Point 3s. When a stock goes from $30 to $45 in 4 days, people get excited. Their outlook is biased toward what has just happened and what has just happened is exciting!
However, Point 3 is a terrible place to buy because the stock has risen on emotion and is due for a pull back. Large computerized traders have a strategy that almost guarantees that a pull back will happen as they will be strong sellers on stocks that run up quickly like this (the strategy is called Mean Reversion).
How do you know when you are chasing after emotion? Notice the green line that I drew on the chart above. It is the upward trend line and I have drawn it across the bottoms on the chart. When the distance from the current price to the trend line becomes large, you are best to leave the stock alone and wait for a pull back before buying. This is another one of my trading strategies, something I call a Pullback Play.
Buy When Others are Panicking
Fear is so powerful that it actually changes how our brains function. When we feel fear, our brain seeks to protect us with the “fight or flight” response that triggers that little part of our brain called the Amygdala. That serves us well when we are being chased by a Cougar, but it hurts our ability to make smart trading decisions when we simply have a fear of losing money.
This fear response causes us to accept a price that is irrationally too low. The farther a stock falls, the closer it gets to the bottom and yet, our fear increases the farther a stock falls. So, our response to fear is more likely to cause us to sell the closer we get to the stock’s turning point from weakness. The Amygdala really hurts our ability to make money in the stock market.
Consider how you felt about your investments in March. My last article for MoneyTalks discussed the tremendous opportunity that the market crash brought, and I showcased a simple strategy for finding stocks to buy (this is the pattern that I show on the chart above). However, I am certain that many readers of that article, perhaps even the majority, thought I was crazy to suggest that it was a good time to be a buyer. The reason was simple; it seemed like the world was ending and taking the stock market down with it. Fear was high.
Since that article, the market is up sharply. The haters that left me disparaging comments on my YouTube channel have gone quiet. A lot of money has been made by those willing to buy in to fear when the market started to turn higher. Buying since March would seem brave, but really, it was just taking advantage of other people’s emotional decision making.
I want to be clear, however, that we should never buy simply because a stock has gone down in price. There must first be a sign that the stock is trying to make a bottom. There are some stocks that go down for very good reasons and deserve to be lower. If we look for stocks that have made emotional sell offs and then start to build rising bottoms on the chart, we are applying a strategy that takes advantage of emotion at a time when the trend is starting to turn. Wait for those signs before trying to catch a falling knife.
Fear and Greed create opportunity if you are on the other side of the emotion. Buy when others are fearful and sell when others are greedy.
Tyler Bollhorn, Stock Scores