Decision making is at the core of stock management. It has rational components and emotional ones. Emotional intelligence is now recognized as a full part of intelligence and persons can be helped to improve it. This knol attempts to collect material regarding the emotional intelligence aspect of stock trading.
Emotional intelligence is:
Understanding / mastering one’s own emotions,
Understanding the emotions of others,
Using those understanding for the benefit of all.
The human factor in trading and the role of emotions
Emotional aspects that traders should be aware of
Positive or negative energy
Whatever the automaticity of some of their behaviors, human beings are not just cold mechanical beings. Emotions are usually needed to drive their actions. A lack of emotion kills the desire to act.
On the other hand too strong emotions, expressing excessive pain or elation, can overwhelm rational thinking and wisdom, affect perception, representation and decision making.
The emotions that might impact trading
- Greed / hope / optimism / wishful thinking, and even magical thinking and illusion of control.
- Fear / aversion / pessimism.
- Sometimes compensated by inventing “good stories” and false beliefs to avoid the pain created by the unknown, the fundamental uncertainty of a complex and changing world
- Emotional asymmetry: the prospect theory shows how players tend to give more mental value to losses than to gain.
- Mental accounts: different risk attitudes / changes of risk attitude according the origins of funds (savings or windfalls). Also forgetting to take into account transaction costs, inflation…
- Haste and hyperactivity (noise trading…) - or procrastination.
- Stress control vs. collapse under stress and uncertainty.
- Willpower and discipline …or the lack or them making for erratic or counterproductive behavior.
- Getting carried away from one’s goals by uncontrolled emotions.
- Independence – Mixed or not with empathy.
- Affect heuristic (personalization): deciding in relation with the pleasant or unpleasant feeling towards a person or an organisation more than via an objective analysis. Madoff’s clients liked him!
- Mimicry, obedience, peer pressure, herd mentality, consensus.
- Also excessive trust in analysts, experts and medias.
- “Foot in the door” (emotional commitment to previous decision, endowment as the feeling that what is owned has more value than what the market offers).
- Overconfidence / pride / narcissism / hubris / illusion of competence or knowledge.
- Envy, a negative feeling towards colleagues which successes are considered undeserved. Such rivalry can lead to disastrous risk taking.
- Neither over- / under- confidence: selflessness / objective wisdom.
Clear or fuzzy motives? What preferences (are they transitive?), goals, needs, motivations ? Do actions have a good chance to meet the goals (a definition of rationality) ? And are those goals themselves “rational” (here in the sense of as far as possible non damaging)? Is for example status / trophy seeking erasing a sense of rational self-interest?
Anchoring to previous reference price or previous situation or previous paradigm. Here we enter into selection biases, focusing on an element and neglecting other, because of cognitive limitations but often also because it would be emotionnally unpleasant to consider other possibilities (cognitive dissonance).
Autopilot behavior (habits, reflexes, even addictions). Although here, emotion as well as cognition are both bypassed by automatic “physical’ reactions to stimuli.
Effects of collective emotions on financial markets
- Market mood / sentiment (collective optimism / pessimism), herd instinct.
- Mistaken collective reactions to events and to information.
- Also underreaction – overreaction by the bulk of market players.
- Trends, cycles, bubbles, crashes, as a result of this underreaction – overreaction collective process
- Collective overconfidence that brings a neglect of – and impreparation for – “rare events” that might destabilize the whole system, for example leading to a systemic liquidity crisis.
- Price and return anomalies / inefficiencies (market distortions that contradict the “Efficient Market Hypothesis”)
- Industry rotation (either short term as market fads and fashions, or long term as industry life cycles)
- Some manipulations by purported experts playing the greed or fear game.
- Stock value perception, stock image
- And so on…
Emotional Competence Inventory
- Emotional Awareness: Recognizing one’s emotions and their effects
- Accurate Self-Assessment: Knowing one’s strengths and limits
- Self-Confidence: A strong sense of one’s self-worth and capabilities
- Emotional Self-Control: Keeping disruptive emotions and impulses in check
- Transparency: Maintaining integrity, acting congruently with one’s values
- Adaptability: Flexibility in handling change
- Achievement: Striving to improve or meeting a standard of excellence
- Initiative: Readiness to act on opportunities
- Optimism: Persistence in pursuing goals despite obstacles and setbacks
- Empathy: Sensing others’ feelings and perspectives, and taking an active interest in their concerns
- Organizational Awareness: Reading a group’s emotional currents and power relationships
- Service Orientation: Anticipating, recognizing, and meeting customers’ needs
- Developing Others: Sensing others’ development needs and bolstering their abilities
- Inspirational Leadership: Inspiring and guiding individuals and groups
- Change Catalyst: Initiating or managing change
- Influence: Wielding effective tactics for persuasion
- Conflict Management: Negotiating and resolving disagreements
- Teamwork & Collaboration: Working with others toward shared goals. Creating group synergy in pursuing collective goals.
So all those experts who are racing to create an effective financial model must make wisdom behavior as its chief pillar along with the current financial expertise. Thus we can have a business model that requires expertise in the field of financial trading along with the emotional expertise to handle the trades wisely. We could call this model – ‘Wisdom Finance‘.
Wisdom finance can be the moat against the herd mentality, panic behavior and greed.
Emotional Intelligence – Some Resources