Trading, the art of buying and selling financial assets, is not merely a game of numbers and charts; it’s a battleground of emotions. In the world of trading, emotions can be both a trader’s greatest ally and their fiercest adversary. The ability to understand, manage, and harness emotions is often the line that separates successful traders from those who struggle or fail.
In this article, we explore the emotions in trading, why we have them, how they’re connected to our genes and instincts, and ways to deal with them effectively.
Understanding the Role of Instincts and Genetics in Trading
Economists and psychologists have extensively studied and widely acknowledged all these biases that humans have, and how these biases negatively affect emotions in trading. The question arises as to why we possess these biases that have such a detrimental impact, making it exceedingly challenging for us to achieve success in trading. Let me break it down for you.
Each of us possesses instincts, which guide our behavior in specific ways. For instance, when a cat falls from a high place, it instinctively knows how to land on its feet. Similarly, when a baby needs nourishment, they instinctively cry, understanding that it will draw attention and fulfill their needs. Numerous examples exist to illustrate this point.
Take sharks, for example: from the moment they are born, they are independent and instinctively know how to hunt, survive, and navigate their environment without external guidance. Hence, these instincts serve as their guiding mechanism, and these instincts are derived from their genetic composition.
Genes serve as a means of transmitting information across generations, allowing individuals to acquire knowledge and traits from their genetic inheritance. The time-consuming nature of learning through genes presents a challenge, which ultimately leads us to the concept of evolution.
For example: individuals exhibit similar types of behaviors as their parents and grandparents.
What is Survival of the Fittest Mean?
“Survival of the fittest” is a concept from Charles Darwin’s theory of natural selection, explaining how evolution works. It suggests that individuals who fit well in their environment and have advantageous traits are more likely to survive, have offspring, and pass on their genes. These advantageous traits increase an individual’s fitness, meaning their ability to adapt and reproduce successfully.
In natural selection, traits that help survival, like physical changes, behaviors, or thinking skills, become more common in a population over time. This happens because individuals with these traits are more likely to live, have babies, and pass on their genes. Over many generations, these helpful traits become more common, making a species better suited to its environment.
It’s important to know that “fittest” doesn’t just mean strong or dominant. It covers many traits that help an organism survive and have babies. Fitness depends on the specific environment and can be different between populations or species.
In short, survival of the fittest means individuals who fit well in their environment are more likely to survive. If someone has traits that work well in that environment, they’re more likely to make it.
Example:
Let’s consider a group of giraffes, most of which have shorter necks compared to the giraffes we typically see today. However, by chance, some giraffes may be born with longer necks due to genetic mutations that occur in their lifetime. The infant giraffe born with a longer neck had a survival advantage since it could access higher parts of trees and feed on foliage that other giraffes couldn’t reach.
Consequently, these giraffes with longer necks had a higher likelihood of survival, enabling them to mate with other giraffes and pass on the genetic trait for longer necks to their offspring. The evolution of longer necks in giraffes was not driven by a deliberate need to strengthen themselves or reach greater heights. Instead, it was primarily a result of chance genetic mutations that proved advantageous for survival in their environment.
Similarly, let’s look at bears. Initially, all bears may have been brown, but by chance, one bear was born with a white fur color. This white-furred bear had a significant advantage in snow-covered environments as it could blend in and camouflage effectively, leading to improved survival. Consequently, it had the opportunity to reproduce and pass on its genes for white fur to its offspring. So, it wasn’t really that white bears were stronger or anything like that. It just happened that they were better suited for that environment.
The same principle applies to humans. Homo sapiens, commonly referred to as humans, have existed on Earth for approximately 200,000 years. When we examine this timeline, we observe that the people who lived 200,000 years ago existed in an entirely different environment. They faced constant threats from wild animals, had to engage in regular hunting for sustenance, and had to find shelter to survive. It was a stark contrast to the environment we experience today.
During that time, individuals who were able to survive in such an environment possessed specific traits. Survival was not attributed to those who took risks, explored beyond their comfort zones, or engaged in venturesome behaviors, as such actions often resulted in danger and potential demise. Those who possessed a more cautious approach, prioritizing safety and adherence to known strategies, were more likely to survive and pass on their genes to their offspring.
When considering the biases we have discussed, such as the status quo bias, it becomes apparent that certain biases would have had different outcomes in the past. For instance, an individual with a strong inclination towards the status quo, preferring to remain in familiar territory, would have had a higher chance of survival. On the other hand, someone inclined towards change and risk-taking, venturing out into the wilderness or engaging in risky behaviors, would have been more likely to face peril and, consequently, not pass on their genes to future generations.
Consider the endowment effect bias, which implies that individuals place a higher value on possessions they already possess and are reluctant to part with them. Our ancestors, too, had this inherent tendency to hold onto their belongings for survival. Those who were cautious and did not give away their food, weapons, or essential tools had a higher chance of survival, as they were better equipped to meet their basic needs. Conversely, individuals who freely gave away their resources were less likely to survive and not pass their genes on to future generations.
All the biases we have explored can be linked back to the environment in which our ancestors lived, as they were highly beneficial for survival in that specific context. The presence of loss aversion, the feeling that losses are more significant than gains, proved advantageous for our ancestors in the past. Their strong aversion to losing possessions or resources helped ensure their survival, as those who were less concerned about losing their belongings and resources faced higher risks and perished. Consequently, the genes we carry today are largely inherited from individuals who possessed this protective instinct of loss aversion.
Yes, we do possess their genetic material. Genes undergo evolution and change over time; however, this process occurs at an extremely slow pace. Consider the example of a machine learning system designed to recognize faces. If you were to draw something on your face or wear glasses, you could easily deceive the algorithm, especially in the case of simple facial recognition algorithms.
However, when it comes to a one-year-old child, they can still recognize you despite any drawings or glasses. This is because the human eye and brain possess the most advanced and accurate facial recognition algorithm known to us. Because the highly sophisticated facial recognition algorithm present in the human eye and brain is a product of millions of years of evolution. Now the problem with that the algorithm is amazing but its slow to change. While we possess remarkably advanced algorithms in the way we think and behave, it is important to acknowledge that these algorithms are still predominantly shaped for the environment of our ancestors.
When examining the timeline, it becomes evident that the first civilization emerged a mere 5,000 years ago, and industrialization began just 200 years ago. The current scenario of working from home in front of a computer is an exceedingly recent development. The challenge lies in the fact that we currently find ourselves in a new environment, one without the constant threat of tigers chasing us, where we have access to comfortable beds, abundant food in the kitchen, and social security. However, despite this shift in our environment, we still possess the same genes, emotions, and behavioral patterns as our ancestors who lived in vastly different circumstances.
When engaging in trading, the concept of money comes into play, symbolizing shelter, food, and the ability to provide for oneself and reproduce. Interestingly, the same primal emotions and fears that our ancestors experienced when lacking sufficient food or being pursued by a tiger can be triggered when dealing with large sums of money in trading scenarios. because money is everything. When engaging in trading, the emotions and responses we experience are akin to those felt by individuals in ancient times. This similarity is evident in the activation of our fight or flight responses and the manifestation of biases that helped our ancestors navigate their survival in that environment.
Managing Emotions in Trading
While emotions are an inherent aspect of human nature, successful traders learn to manage and channel their emotions constructively rather than allowing them to dictate their actions. Here are some practical strategies for managing emotions in trading:
Develop a Trading Plan: A well-defined trading plan serves as a roadmap for navigating the markets and helps traders maintain discipline amidst fluctuating emotions. By outlining entry and exit criteria, risk management strategies, and predefined goals, traders can mitigate the influence of emotions on their decision-making process.
Set Realistic Expectations: Unrealistic expectations often lead to disappointment and emotional turmoil in trading. Traders should set achievable goals and understand that losses are an inevitable part of the journey. By embracing a realistic mindset, traders can reduce the emotional impact of setbacks and focus on continuous improvement.
Practice Self-Awareness: Self-awareness is key to recognizing and managing emotions effectively. Traders should cultivate mindfulness techniques such as meditation or journaling to develop greater self-awareness and emotional resilience. By observing their thoughts and feelings without judgment, traders can avoid impulsive reactions and make more rational decisions.
Implement Risk Management: Proper risk management is essential for mitigating the emotional stress of trading. By limiting the size of each trade, setting stop-loss orders, and diversifying their portfolio, traders can minimize the impact of individual losses on their overall capital and preserve their mental well-being.
Take Breaks and Rest: Trading can be mentally exhausting, particularly during periods of high volatility or sustained market downturns. It’s crucial for traders to prioritize self-care by taking regular breaks, getting adequate rest, and engaging in activities outside of trading to recharge their batteries and maintain emotional equilibrium.
Conclusion
Most individuals struggle with trading because our brains aren’t naturally wired for it, given the differences between our current environment and the one our brains are adapted to. Sitting at a desk for long periods and staring at screens is quite different from what our brains are used to.
When we face financial gains or losses, which our brains might perceive as threats to our access to food and shelter, it’s hard to stay calm and think logically.
We’ve inherited biases from our ancestors, and these biases are deeply ingrained within us. They’re a part of who we are, whether we like it or not.
Challenging these biases is tough. But once we commit to learning new behaviors and see the benefits, it gets easier.
To make a change, we need to trust ourselves and be willing to go against our instincts and initial feelings. Starting the process and seeing positive results can help us embrace and maintain the change.
Whether or not you agree with this theory, it sheds light on why we have biases and how they stick with us, regardless of our personal opinions.
Check this article from Harvard Business Review by Nigel Nicholson