Trading Psychology Key indicators for Understanding

Mind games

If you are part of a WhatsApp group related to stock markets, there is a good chance that you have seen this video a few years earlier- https://www.youtube.com/watch?v=_aSngISnKwQ

Here’s a synopsis. On this show, viewers call in to ask the program host enquiry about the stock market. One caller in this video clip requested assistance with converting 20,000 shares of MRF LTD from ‘physical certificates’ (paper form) that his grandad purchased in the 90s, to digital form.

After giving the caller an explanation of how to transfer their shares from the physical form to DEMAT form, the show host mentioned what those shares would be worth in today’s market.

The price per MRF share was around Rs.64,000/-, resulting in his total of 20,000 shares being worth a grand total of –

20,000 * 64,000

= 1,280,000,000

Or about Rs.128 Crores.

Can you imagine that – ONE TWENTY-EIGHT Crore!

I was shocked when I saw this video for the first time.

The first thing that came to my mind was, how could somebody have the foresight to invest in MRF 25 years ago? What is it that is inspiring him to stay committed? How did he resist the urge to sell, especially when bearing witness to such impressive gains on his initial outlay?

I’d say that a typical investor would likely dispose of their holding if they had seen returns of 50%, even 100% or, at most, 200%. However, this individual has maintained ownership of their stock over extended periods and enjoyed growth of 20x or 2000%.

What caused this to occur?

If we can come to comprehend the situation, it might offer us a number of ideas that could assist us in forming our own fortune.

After taking a second look and viewing the video again, I was able to comprehend what was happening. My observations include…

• His grandfather bought MRF shares a long time ago, but hasn’t paid much attention to them since then.
• On a certain day he realised that he possessed some MRF shares stored in his attic.
• He must have spoken about this to his grandson (the caller).
• The grandson has now decided to convert them to DEMAT

This situation is highly intriguing. There are several potential outcomes and it is difficult to predict the final outcome.

It appears that the grandfather has most likely overlooked his investment and devoted his time to something else.

It is reasonable to assume that if he had wanted to convert these shares to DEMAT, he would have done so already.

Since he had overlooked it, he has not given much thought to how the price increased over time.

What can we determine from this?

You would have to agree, no doubt, that granddad made a considerable sum of money by neglecting his ownership of MRF shares.

Envision the alternative – what if he hadn’t overlooked his investments? Suppose he had an ally or a broker at hand to keep him informed about MRF’s market value on a daily basis?

Do you think he would still be in possession of those shares after all this time? Isn’t it likely he sold them for a large profit, like 100%, 200% or even 500%?

In other words, by not paying attention to his investment, he was rewarded with its benefits over time.

Had he chosen to follow the stock price and stay informed of the newest developments, what could have happened? Examining the data is not merely about collecting facts, it requires examining it with an imaginative eye. Our subjective opinions from a preferred reality can create what we refer to as ‘biases’.

Biases can be the only obstacle preventing you from achieving a positive profit and loss statement in the trading and investing world.

The goal of this and the following chapter is to inform you about some of the most common biases and how to conquer them.

– Illusion of Control

Let us analyse one of the biases that traders and investors often have, by looking at the chart below which is a common sight on any technical analyst’s desk. There is a lot to be observed here –

1. Candlestick chart for price action
2. Bollinger band to track volatility
3. Fibonacci retracement to identify retracements
4. Pivot points for support and resistance
5. Volume chart
6. ATR
7. Stochastic indicator

I’m certain that at least 8 in 10 technical traders would have a similar setup when viewing charts. For someone who isn’t conversant about charts or technical analysis, this may look complex and daunting due to the numerous components and calculations taking place.

This chart provides the trader with distinct insights, and also works on their subconscious without them realising it.

Due to its complexity, many cannot comprehend what is represented in the chart; however, the trader feels in control of the stock market with all of his ‘key information’.

This phenomenon of misplaced confidence is widely referred to as the ‘illusion of control’: a common behavioural bias among technical traders. Such individuals will often state things like “This stock won’t go over 500” or make bold claims such as “Definitely buy puts”, without being able to provide any clear explanation when asked why.

What prompts them to take this action?

Traders often gravitate toward complex things, since there is something pleasurable in attempting to make sense of complicated charts. It almost feels like a challenge – markets are so intricate, the natural response is to take on the beast with hefty analysis. Furthermore, the exclusive knowledge of how it all comes together gives an extra satisfaction.

This is due to a physiological behaviour called ‘illusion of control.’

No matter how many indicators you load or numbers you crunch, it is impossible to control all eventualities when it comes to the markets. Ultimately, there are multiple results available for each given scenario and you cannot account for all of them.

To be successful in any trading endeavour, you must stay focused on the results and associated statistics. Being aware of the potential for profitability in each trade enables you to realistically assess market opportunities. Furthermore, it puts you in the position of being honest with yourself (and those around you), and helps to prevent hubris from taking hold. Ultimately, it keeps you from being distracted by superficial elements.

My market experience has taught me one thing with certainty – keeping things straightforward is the best way to analyse. Complexity does not mean improved outcomes, so traders should stay alert and construct an information-driven methodology instead of being influenced by insignificant elements.

– Recency Bias

No matter how much knowledge one possesses, at some point, they may become victims of bias. To demonstrate this with a recent example, I found it rather intriguing.

If you had tracked ‘Café Coffee Day Enterprises’ (CCD), then you would be aware of the current situation concerning the company and its stock. For those who are not familiar—the Income Tax Department had investigated the organisation for dodging taxes and retaining substantial sums of money. A few years ago, Economic Times ran a detailed report about it, with this headline:

My position on long-term investments has always been clear – if the company’s corporate governance is uncertain, I steer clear no matter how profitable it looks. History has evidence of such big blunders and in view of what happened with CCD. 

My friend, who is family, reached out to me after a couple of days following the CCD scandal. Although things had been smoothed over by that point, the concealment of earnings was still an issue. I suggested he pull out and he requested I review the company’s chart.

After the dip, the green candle indicates there may be some buying activity in the stock. It is likely that a few traders or investors attempted to capitalize on the bargain prices.

If the objective is to leave due to corporate governance matters, then there’s no question of not doing so. My friend proposed that maybe he should wait a few days before disposing of the stock; this might fetch him a more desirable price.

I didn’t press the matter any further; there was no point in trying to persuade him to discard the sock.

My friend is being affected by ‘recency bias’, being completely taken in by the recent green candle and overlooking the past events. He believes there’s further potential to gain from the stock, however, disregarding corporate governance and suitability for investment.

Recency bias skews your judgment, causing you to give disproportionate weight to a recent event when perhaps it is not warranted.

To combat recency bias, you must take into account the bigger picture. Don’t get too fixated on one singular view, but instead see the entire situation holistically.