Cognitive dissonance and trading

The old saying “the trend is your friend” is easily one of the most widely used and accepted aphorisms of the markets. Looking back at what the market has done since March of 2009 it is easy to see why the trend is indeed your friend. It’s also easy to see why so many market participants, even seasoned ones, are in disbelief of the move. Obviously we all can’t be on the same side of the trade as we wouldn’t have a market.  However, digging a bit deeper than that is a common pitfall experienced by many traders.

Cognitive dissonance is the mental conflict that people experience when they are presented with evidence that their beliefs or assumptions are wrong. Humans have the tendency to go to extreme measures in order to protect their belief structure. This type of protectionism manifests itself in the market through “doubling down” or “dollar cost averaging” a position.

An example where traders experience dissonance is when the self-concept is attacked. For instance, the self-concept of being a good/smart/profitable trader might be under attack. A trade was placed, maybe hastily, and now it’s under water. The anxiety that comes with the possibility of having made a bad decision leads to rationalization, then the doubling down, etc. begins. This is low probable trading and can lead to large losses.

Over the years I’ve worked with some great people yet they were horrible traders. They were too stuck on the fact that they needed to be right, regardless of the cost. The market doesn’t care who you are, how much money you make, or how many degrees you have. I can’t stress enough the importance of a trading plan—at a minimum you should know the target and the stop. Traders are proven wrong every day in the market and it’s those that take expected losses and move on that survive.

One of the six facets in the Neuroticism trait of the MAP is Self-consciousness. Self-conscious traders second guess discretionary trading decision and should consider a more mechanical method. Low scorers, in contrast, feel confident they’ve made a good decision and can be successful as picking stocks. However, where poor trading may occur is a low score on this facet and a low score on the Dutifulness facet of the Conscientiousness trait. Add to the mix a high score on the Assertiveness facet of the Extraversion trait and a potion for disastrous trading can ensue.