Many traders think that sentiment determines trend investing. They study the greed and fear of others when making their trades. But research shows that this is not the path to high returns. Successful traders eschew the actions of others and make independent decisions.
Do you really know the difference between a trader and investor?
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You look inward and attempt to understand your own cognition and decision-making process. You learn about behavioral biases, cognitive dissonance, self-justifying rationalization, and the probability of error.
Most importantly, successful investors put their egos aside. They consider what is most likely to benefit them rather than make them feel good about themselves. It also covers why researchers have found that it’s not trading mistakes that make a better investor, it’s deep introspection.
Trend investing and trading are very different. The strategies and timelines are far apart because the two activities have different trading goals. Which one you are best suited for depends on your personality. It also consists of your risk tolerance, and your available resources; namely, capital and time.
Traders are typically focused on short-term financial gains. This can sometimes be in the region of 10% or more each month. Trend investing traders are constantly analyzing charts to make quick moves with short timeframes. Trading is fast, furious, and risky, and can be a full-time job. There are day traders who buy and sell within one day. There are also swing traders who might hold a position from days to weeks.
Traders typically need an account balance of at least $25,000 to trade stocks in the United States. Swing traders may need a balance of $10,000. Those who buy and sell over longer periods—weeks or months—are typically not subject to minimum capital requirements.
Traders tend to like risk. To make money, they must consistently time the market correctly. This is very difficult to do. According to the trading platform eToro, 80% percent of traders lose money. They often do so due to impatience and behavioral traits.
Successful investors are a less emotional breed. Their goal is to build wealth over the long term—from years to decades. Investors look for securities that will perform over time by evaluating market fundamentals. They hold securities despite dips in the market. They also look for slower less dynamic returns in the range of 8-15% annually. Buy-and-hold investors gain from additional revenue streams. Examples include income from interest, compounding, dividends, and stock splits.
Investing requires an upfront time commitment to research market fundamentals. You will also need to be ready to analyse long-term growth potential. Investors make fewer transactions, so costs and taxes are less than for trading. However, investors must watch for fees associated with mutual funds that could eat away at returns.
Successful investors have a different mindset from traders, as they do not react to day-to-day price fluctuations. They do not panic when markets and securities dip. They have a steely countenance that prevents them from making rash decisions and succumbing to a herd mentality.
Are you cut out for trading or investing? Do you thrive off a roller coaster ride of emotions? Or are you a disciplined machine with thick skin, who is not easily offended or influenced? Do you even know how your emotions affect your decisions?
A cursory dive into successful investors’ skills and character traits reveals in-depth studies on behaviors like discipline, analytical skills (obviously), patience, and risk aversion. Ultimately, trend investors, if they want their strategies to pan out, need to develop a long-term plan and stick to it. They cannot become fearful or lose confidence when the price of an asset tanks.
These are all great talking points, but where do these conjectures actually come from, and why?
Warren Buffett is one of the most lauded investors of modern times. Look no further than his success to find the important traits for investors. After all, he is the proven master. Here are two of his quotes related to investor characteristics.
“Inactivity strikes us as intelligent behavior.” In other words, do not react to market fluctuations.
“The only value of stock forecasters is to make fortune-tellers look good.” The prophecies of a fortune teller are more reliable than those of a learned day trader.
“We continue to make more money when snoring than when active.” Well, perhaps, but it helps to have billions of dollars stashed neatly away in a safe and diversified portfolio.
You might reject Warren Buffett’s proselytizing considering that he has amassed so much wealth under much different economic and market conditions. Why listen to Buffet when he can indeed snore his way to billions with a static stock portfolio, market dips and all.
However you explain Buffett’s wealth, he has consistently taken winning positions over the long term. Is that luck or an understanding of the human condition? Buffet aside, there is a growing body of research that shows that trying to time the markets is a sure path to poor results.
According to researchers of behavioral finance, some character traits are detrimental to investing success. For example, overconfidence and behavioral biases. Specific behavioral biases are activity bias, trend-following or representativeness, herding, loss aversion, and familiarity bias. Let’s explore these so that you can decide whether they apply to you, and if you think they don’t, you’ve fallen for the first trap.
Being overconfident is fine when the stakes are inconsequential, but that’s rarely the case where trading and investing are concerned. An individual investor who thinks they know more than the market is setting themselves up for disappointment.
Kent Daniel and David Hirshleifer, authors of the paper “Overconfident Investors, Predictable Returns, and Excessive Trading,” cite a wealth of literature showing that people tend to be over-optimistic about their life prospects, and this optimism directly affects their final decisions. Overconfidence has been documented among corporate financial officers, stock brokers, and investment bankers, all of whom overestimate their ability to predict stock returns.
People fall prey to overconfidence partly because they credit their talent for successes and blame their failures on bad luck. This allows overconfidence to persist because traders congratulate themselves for timing the market right, but then fail to check themselves when they don’t. Overconfidence leads to more trading, and the more actively investors trade, the more they lose.
Brad Barber, Xing Huang, Jeremy Ko and Terrance Odean, authors of the August 2019 study “Leveraging Overconfidence,” hypothesized that “overconfident investors with a budget constraint use leverage more, trade more, and perform worse than well-calibrated investors.”
The authors conclusion? “Our analysis suggests overconfidence and leverage can be a dangerous mix.”
As human beings, we tend to want to be active, particularly when we are stressed, because we are impatient to achieve our goals. However, as Warren Buffet contends, inactivity is better for investors.
A 2012 study of investor behavior by Dalbar Research, found that the average investor in U.S. equity mutual funds severely underperformed over the prior twenty years. Excessive activity, impatience in other words, costs investors over 50% of their potential wealth.
Professional investors exhibit activity bias as well. Professional investors tend to swap stocks in an attempt to gain an edge, but trading activity is costly and usually detrimental to returns.
A 2018 study by Roger Edelen, Richard Evans, and Gregory Kadlec called “Shedding Light on ‘Invisible’ Costs: Trading Costs and Mutual Fund Performance” found that mutual funds with turnover and trading costs were in the lowest quintile had returns 1.78% per year higher than the returns of the firms with the highest trading costs. The takeaway? Trade less.
Traders study charts and trends as part of their strategy to predict market movements. This assumes that future price movements are dependent on all other things being equal, which is never the case. The future is uncertain, and many factors will change.
A study released by S&P Dow Jones Indices, “The S&P Persistence Scorecard,” looked at the success of active fund managers. They focused on whether it was a result of predictive trend-following skills or merely luck. The study concluded that “irrespective of asset class or style focus, few fund managers consistently outperform their peers,”. This implies that neither trend analysis nor luck was much help.
Rather than obsess over charts and patterns, it’s better to buy a stock you believe has long-term potential and forget about it.
Investors have to turn off innate human instincts to be successful. Humans are mammals, and herding behavior is a survival trait common to our species but, regrettably, not one that serves the modern investor. Following other investors is the opposite of what an investor should do.
A study by Bhoomika Trehan and Amit Kuman Sinha entitled, “Investigating Investors’ Herd Behavior,” concluded that herding is a cognitive bias and a causative factor in the creation of bubbles. The Internet stock bubble was an excellent example of massive herd behavior that lost fortunes. Pompian, author of a 2006 paper on “Behavioral Finance and Wealth Management,” contended that investors “become bewildered by their own hesitation; they step back and follow the herd.”
An independent constitution when stocks are tumbling or exploding is counter to our short-term instincts but necessary for long-term financial gain.
Behavioral bias is dangerous because it prevents an investor from diversifying and reducing their exposure. Familiarity bias is the tendency to only buy stocks we have an affinity with—perhaps we like the company or we know a connected family member.
A 2021 study by Vladislav Zhdanov and Artem Simonov, entitled “Sell Winners and Buy Losers? The Impact of Familiarity on Individual Investors’ Decision-Making: Experimental Results,” found familiarity bias reinforces individual investors’ reluctance to realize losses.
Respondents who managed familiar portfolios bought fallen assets 1.10 times more often than the holders of unfamiliar portfolios. Individuals preferred to buy losers when the assets were familiar to them.
Not only that, but the authors found a correlation between familiarity and risky trading. Familiarity with assets caused individuals to carry out higher risk-trade transactions. In other words, familiarity trading bias reduces individual investors’ trading performance.
Studies have shown that humans experience a far greater emotional reaction to a financial loss than to a financial gain of the same amount. This loss aversion can negatively influence an investor who may avoid selling a bad investment or realizing a loss because they want to avoid the pain.
According to the Nobel Prize winner in economics, Richard Thaler, author of the book “Misbehaving,” this is relevant for investors because if you tend to check your portfolio often, you will net out with more pain than joy and may experience myopic loss aversion.
Thaler found this out after conducting a study with Schlomo Benartzi for their paper “Myopic Loss Aversion and the Equity Premium Puzzle.” Using historical evidence for the S&P 500 Index (1950–2014), the authors found that investors who check their portfolios daily can expect to see losses 46% of the time and gains 54% of the time. However, even though there are more gains than losses, because people feel the pain of loss with twice the intensity than joy from an equal-sized gain, the more often investors check their portfolio values, the more net pain they will feel.
The study also showed that investors who reviewed their values quarterly instead of daily (for example, those with a quarterly statement from a 401(k) experienced a shift from net pain to net joy. This effect was even more pronounced when they checked their portfolios annually.
The takeaway is that the more frequently you check your portfolio, the more tempted you will be to abandon your investment and avoid pain. So, the less you watch the financial media and pay attention to economic and market forecasts, the more successful you are likely to be.
So many of the behavioral biases that we have mentioned are innate human characteristics, but that does not mean we cannot retrain our brains. The Adaptive Market Hypothesis, developed by Kalugala Vidanalage Aruna Shantha in their paper, “Individual Investors’ Learning Behavior and Its Impact on Their Herd Bias: An Integrated Analysis in the Context of Stock Trading, “ suggests that behavioral biases have evolved; thus, individuals can learn from their behavioral mistakes and adapt to market conditions over time. However, there is a caveat.
The authors find that it is not past trading experiences that directly produce learning. Rather, it is cognitive self-reflection that causes us to learn and change our behavioral biases.
You may think you have done your due diligence when it comes to trend investing. But unless you’ve examined your own psyche and capacity to deny innate behaviors and biases, you are probably not ready for trend investing.
If you thrive on risk and excitement, have plenty of capital, and need an all-consuming hobby, trend investing through day trading might be your thing. In contrast, if you have looked inward and attempted to understand your own cognition and decision-making, if you can put your ego aside and make independent decisions, you might be on the way to learning enough to be a successful trend investor.
It’s such an anomaly in finance is that although many investors idolize icons like Warren Buffett, they fail to follow his advice and do exactly the opposite of what he recommends. How capable are you of denying the human condition?