How I Learned to Avoid Emotional Stock Trading
When we trade on emotion, we tend to do the wrong thing for the wrong reason. For example:
- We buy a stock in hopes that it will go up. Then it goes down, and we hold on because our ego would be hurt if we admit we were wrong.
- We also tend to buy too high at times because we see a stock going up and we want some too. We end up buying at the highest price, out of greed, and then the stock tumbles.
- We don’t want to admit we are wrong, so we ride a bad trade down, making it even worse.
- We do get out at some point, but not when we should. We get out when the pain is too much.
I’ve been trading stocks and options for over 40 years and I’ve discovered that the only way to really be successful is not eliminate emotion. It wasn’t easy. My ego would get in the way. My greed would interfere.
The only way to control emotions with stock trading is to make it mechanical. I’m not talking about using software or any kind of process that runs automatically. I’m talking about making your own actions mechanical.
It’s a strategy where you follow a strict plan. Entering and exiting every trade is based on that plan, no matter what else may affect your decision.
That is easier said than done, but it’s doable as long as you’re diligent about it.
Mechanical Investment Plan
Remember, the idea is to remove emotion from our trading and to not let ego get in the way. Therefore we can increase our chances of buying low and selling high, instead of selling low out of panic, or buying high out of greed.
We need to exercise a precise buy and sell protocol that does not involve any decision-making. This is how we avoid letting emotions get in the way.
Many people find that they get too involved with what's happening with individual companies and they base their buying or selling decisions on what they hear on the news.
Again, that's emotional trading. It's better to trade an index of stocks, such as the S&P 500. This is an exchange traded fund (EFT), so you can buy and sell just like a stock.
Based on your level of risk and the amount you have available for trading, choose an amount that you will invest in equal sums at a time. For the sake of this example, lets say $1,000.
Implementing the Plan
A good rule when you are trying not to pay attention to specific stocks is to use an index fund, as I just mentioned. I like to trade the S&P 500 index (symbol SPY).
Start by buying $1000 of SPY on the first trading day of next month.
Then, on the first trading day of every month (on an ongoing basis), do one of the following:
- Buy $1000 worth of SPY if the SPY is lower than it was on the first trading day of the prior month.
- Sell $1000 worth of SPY if the SPY is higher than it was on the first trading day of the prior month.
You may need to round up or down since SPY does not trade in fractions. You may use a different amount for each trade, and you may use a different time period other than monthly. Whatever you do, keep it consistent. Maintaining consistency is being mechanical.
Some brokers will let you specify the dollar limit and they will adjust the shares accordingly, as shown in the example below:
Always do the trade at roughly the same time of the day as well. Otherwise you’ll let emotion play with your decision. You’ll find yourself deciding to wait an extra hour or two on a fast moving day, thinking you’ll get a better price. This can help, but it can also go against you.
Whenever you buy a stock, you always have a 50/50 chance of a stock going up or down. This is true for ETF’s also. With odds as even as that, it makes no sense to wait. Trade based on the rule, not on emotion. Let’s be completely mechanical.
- Trade on the same day each month.
- Trade at the same time of the day.
- Trade based on the rule, not on emotion.
Consideration of Commissions
There’s always a catch, isn’t there?
You need to consider commissions when deciding what your monthly trade amounts should be. I used $1000 as an example, but if you pay $10 per trade and you trade $1000 monthly, you are paying 12% per year in commissions. That might defeat the purpose of this plan.
Some brokers do not charge commissions for certain ETF’s. Check with your broker.
One example: Charles Schwab’s ETF OneSource™ account is commission-free to trade some specific ETFs online.
If you do pay a commission, calculate that into the price when executing the plan to buy or sell a fixed amount each month.
Larger trades will reduce the effect of commission. Whatever amount you decide to use, keep each monthly trade the same. At least as close as you can when rounding to whole shares.
Be Strict and Don’t Think
Being mechanical means that you should never manipulate things in any other way. Don’t change the amount of investment. I use $1000 as an example. You can use any amount, but don’t increase it just because you're becoming greedy. Don't lower it out of fear.
Just stick to the mechanical nature of carrying out the plan. Fear and greed are two emotions we want to avoid. Remember, this plan is meant to be mechanical. You need to keep repeating that to yourself. I know I needed to in order to remain strict. It works once you get the hang of it.
What can happen when you don't stick with the mechanical method of consistency? I'll give you an example.
One month SPY may be so far down that you want to double your next investment. Don’t do it. It may be lower the following month. Remember, the chance of going in any direction is always 50/50, no matter how far it moved up or down. Believe me. It took decades for me to learn that, even though I always knew it from a statistical viewpoint that I learned in college.
The beauty of mechanical trading is that we don’t need to think. We don’t need to follow trends, or the news, or individual stocks. We just carry out the trades according to plan. Mechanically!
What’s the Benefit?
If things go according to plan, we will enhance our ability to buy low and sell high. We will constantly be taking some money off the table at a profit, rather than holding too long until things turn against us.
We will also be cost-averaging as we buy more shares at lower prices and take some money off the table at higher prices. This also creates the effect of recycling our money, so it’s almost like creating an endless stream of funds in a sort of way.
What Can Go Wrong?
I’m ending this article with the worst scenario, it wouldn’t be complete without it.
Of course, nothing is a sure thing. World economies can worsen. World events can have a powerful negative effect on markets, and this will defeat the purpose of using a general diversified investment of an ETF.
You could find yourself putting $1000 into your account endlessly every month because the ETF keeps going lower and lower until you lose it all.
The theory is that the stock market won’t go to zero, but one never knows.
A Final Thought
Despite the negatives with a constant down-market, this plan forces you to invest with dollar-cost-averaging, buying more and more shares at lower and lower prices.
When the market turns upward again, you’ll have accumulated a lot more shares at better prices. And you’ll be selling at higher and higher prices per this plan, if you stick to it.
What do you struggle with the most?
The strategy I discuss here is for educational purposes only. I am not making any trading recommendations. You are solely responsible for your own investment decisions.
© 2014 Glenn Stok