This article is based on my experience from over 45 years of perfecting my stock-trading strategies and risk-control skills.
What Happens When You Trade Stocks Emotionally?
In this article, I’ll explain how emotions negatively affect your trading decisions and how I learned to avoid it with a pre-defined plan to improve results.
Emotional trading causes you to sell when you see losses because you feel the pain. Conversely, it will cause you to buy when you see stocks rising because you want to ride the trend emotionally.
However, either of those cases becomes a losing trading system because you could end up buying high and selling low.
A healthier method is to learn to follow a strict pre-defined plan instead of trading on emotional feelings.
Why We Do the Wrong Thing When Emotions Guide Us
When we trade on emotion, we tend to do the wrong thing for the wrong reason. For example:
- We buy stock in hopes that it will go up. Then it goes down, and we hold on because it would hurt our ego if we had to admit we were wrong.
- We tend to buy too high because we see a stock going up, and we want to get in on the action. 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 we reach our pain threshold.
As you can see, when trading stocks on emotion, we tend to do the wrong thing. Instead, we can improve results by entering and exiting every trade based on a specific, pre-defined plan and sticking to it.
Self-discipline is essential for successful trading. So let's review all that in detail.
How to Take Emotions Out of Investing
The only way to control emotions with stock trading is to make investment decisions based on a pre-defined plan. That is known as mechanical trading, making your actions follow a strict rule of implementation.
When you have a pre-defined plan, and you follow it instead of letting your emotions get in the way, you can increase your chances of buying low and selling high. That's how to avoid selling low out of panic or buying high out of greed.
To explain that another way, you need to exercise a mechanical buy and sell protocol that does not involve any decision-making.
Implement a Mechanical Trading Plan
You can do this with any stock, but I'll use the S&P 500 (symbol SPY) in my examples. That's an Exchange-Traded Fund (EFT), an index of 500 stocks in the S&P that you can buy and sell just like a single stock.
Based on your level of risk and the amount you have available for trading, choose an amount you want to invest on an ongoing basis. For this example, let's say $200 per month.
Start by buying $200 of SPY on the first trading day of next month.
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Then, on the first trading day of every month, do one of the following:
- Buy $200 worth of SPY if the SPY is lower than it was on the first trading day of the prior month.
- Sell $200 worth of SPY if the SPY is higher than it was on the first trading day of the previous month.
You might need to round up or down since SPY does not trade in fractional amounts. You may use a different quantity for each trade and another period other than monthly. Whatever you do, keep it consistent—that's being mechanical.
Some brokers will let you specify the dollar limit, and they will adjust the shares accordingly, as shown in the example below:
Trade at a Specific Time of Day
Always make the trade at roughly the same time of the day. Otherwise, you’ll let emotion play with your decision, deciding to wait an extra hour or two on a fast-moving day, thinking you’ll get a better price. That can help, but it can also go against you.
Remember, anything can go wrong when you let your emotions guide you. Whenever you buy a stock or ETF, there is always a 50/50 chance of the price going up or down. So it makes no sense to wait for a better entry or exit point with odds as even as that.
Don’t Overthink Anything
By being mechanical, you'll never manipulate things against the rules.
You already made your plan—stick to it. Don’t change the amount of investment. You can use any amount, but don’t increase it because you're becoming greedy, and don't lower it out of fear if the stock is dropping.
I'll explain why these emotional responses work against you.
One month SPY may be so far down that you want to double your next investment. But don’t do it. It may be lower the following month.
You already would be getting more shares because you're investing a fixed amount each time. Be happy with that. It's known as dollar-cost averaging.
What if the stock goes higher? At first, you're upset that you didn't put more into it. Right? Then you want to put more into it because you feel you want to catch up. That's greed!
I use a trick by asking myself, "Am I doing this out of greed?" But when I stick to a plan, I don't even need to think about it.
The beauty of mechanical trading is that you don’t need to think. You don’t need to follow trends. Just carry out your trades according to the plan—mechanically!
What’s the Benefit of Mechanical Trading?
When you follow the plan, you will always buy low and sell high. Thus, you will continuously be taking some money off the table at a profit rather than holding too long until things turn against you.
You will also be dollar-cost averaging as you buy more shares at lower prices and take some money off the table at higher share prices. Of course, that also creates a routine of recycling your funds.
What Can Go Wrong?
Nothing is a sure thing. World events can negatively affect markets. If the stock or ETF keeps going lower and lower, you could invest $200 endlessly every month until you have no funds remaining. And you may never have the opportunity to take money out at a profit.
Of course, the theory is that the stock market won’t go to zero. But to be honest, one never knows. You may need to change your plans if a crisis develops, such as war. That's the only time you'd sway from using a mechanical technique.
A Quick Review
You'll see better results when you trade consistently according to a specific plan.
- Enter trades mechanically based on a plan.
- Trade on the same day each month.
- Trade at the same time of the day.
- Don't overthink anything.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2014 Glenn Stok