Why do smart traders make stupid mistakes?

The vast majority of traders start their careers in the markets with a demo account and many of them learn quickly to trade profitably... until they start trading with real money.

But many of these same traders who can accurately assess opportunities and invest without fear using virtual money become unprofitable, hesitant and shy individuals when they have to do the exact same thing with real money.

The emotional impact of the risk of losing money eliminates all cautious and well-designed trading plans, which disappear in a fog of fear, uncertainty and doubt.

• The psychological differences between demo and real trading
• Tips for switching to a real trading account

Why do many traders end up acting like idiots... or like they've gone crazy?

Why do traders go crazy when real money is at stake, and why does it happen so often, are some of the topics that were explored by Dr. Janice Dorn and Dave Mente Harder in their book Mind, Money & Markets: A Guide for every Investor, Trader and Business person.

Mr. Harder is a highly respected Canadian banker who has spent the last 30 years as an active and successful investment advisor. Dr. Dorn is an Arizona-based physician trained in psychiatry with a PhD in neuroanatomy who is actively involved in the psychology of trading.

The book is full of tips for long-term investors, but their work on trading psychology is also deeply relevant to short-term trading, which most traders seem to specialise in, especially beginners. The central question is: how can traders and investors learn to make the right decisions when they are hit by unexpected market events? How can they avoid irrational impulse behaviour and the negative emotions that overcome them when things go wrong?

In other words, why do traders, who are usually very smart people, do stupid things, such as clinging to losing positions and reducing profits by cutting trades too early?

The lizard's brain

Nothing evokes a stronger emotional response than losing money, and as Dr. Dorn shows, when the market goes against a trader, the part of his brain that responds is the limbic system, the part that some researchers call the "lizard brain". This part of the brain was once responsible for allowing us to have quick and unhesitant reactions when danger threatened our ancestors in the African savannahs.

When we invest in the financial markets, spontaneous and rapid reactions are disastrous. Such decisions neglect the part of the brain that produces calculated rational responses that can help a trader protect his capital... and his mental health.

Here is an example that all traders will surely recognize: suppose a trader opens a buy position with a protective stop below his entry point. To the trader's surprise, the market drops to the protection stop. Instead of allowing the price to reach the stop loss, he decides to move the stop loss lower until the market bounces, and when the price falls below this level, his losses begin to accumulate.

If the trader is smart, he gets out of the market and curses his stupidity for moving the stop loss lower.

But he is not sure. He thinks that the market will recover and soon rise sharply. After all, it was a good trade, and it is much better now that the market is lower. The trader decides to maintain or even increase his position size, as this will allow him to reach the breakeven point or even make a small profit when the market recovers.

This is called downward averaging. Everyone knows how stupid this practice is, because you end up risking a lot of money just to avoid a small loss. And virtually all traders (including the very best traders) have done it. And worst of all, when the trader swallows his pride and assumes his losses, the market goes up. Then he said to himself, "If only I had held on a little longer, it would have worked, and next time I will not stop so fast." And what usually happens is that the market doesn't turn around and the trader ends up losing all of his trading capital.

But I'm too smart to do that!

If it was just a question of intelligence, almost no trader would fall into this negative behaviour trap. But when the time comes, stubbornness, pride, reluctance to admit failure, negative reactions to losses, false hopes, self-delusions and a host of other emotions obscure good judgment, and the trader stubbornly clings to his mistake.

Another problem is that sometimes this behaviour works. The market recovers and the trader manages to avoid a big loss. And of course, he does it again every time he gets caught in a bad position. But it only takes one big loss to be out of the race, and the trader will always lose his money by following this type of behaviour. The above-mentioned book is full of tragic examples of successful traders who ended up losing billions because of this typical beginner's mistake.

The second consequence is that the trader starts taking profits whenever he can, even when the trade promises bigger rewards if the trader leaves the position open while the market slips into a range. The fear of seeing a small amount of profit slip out of his hands is about twice as strong as the greed that drives a trader to trade in the first place; the emotional pain of losing is much stronger than the thrill of winning. Before recognising what is happening, the trader cuts his winning trades too quickly and lets his losing trades continue to run while losses accumulate. This is very common and occurs very easily, traders are more likely to take risks on unrealised losses than on latent profits.

How can I avoid this common mistakes?

This is a complex question. A company specialised in training traders offers a 10-week course designed solely to help new traders survive their first 4 months on the market. Mind, Money & Markets uses several methods based on technical indicators to help long-term traders properly manage these complex emotional issues.

Short-term traders have the advantage of encountering these stressful events much more frequently, and will therefore be better prepared to deal with the next obstacle.

Below are a number of practical steps that traders can use to trade safely and be less likely to make the mistakes described in this article:

• Correctly determine the size of your positions. Mental errors occur most often when you take too many risks. More experienced traders use a spreadsheet to calculate the maximum size of each trade and the maximum loss allowed each day, week, and month. Disciplined and smart traders stick to it.
• Leave your protective stops in place. Sooner or later, all traders see some of their trades closed at a loss when the price reaches the stop-loss. When this occurs, the trader can assume the loss and decide if he wants to re-enter the market in the same direction and look for a better entry price, or he can stay away and wait for more favourable conditions. It's a lot smarter than hanging onto a losing trade just to see the losses increase more and more.
• Keep a trading journal. Record the trades made each day: the result, the reason for the entry, the entry price, the exit price and the emergency response if the market moves in the opposite direction. Online trading is deceptively simple; a click of the mouse is enough to wipe out your account if things go wrong. Keeping a trading journal imposes discipline.
• Use technical analysis to plan entries, exits, and stop losses. It is impossible to be right in every trade, so traders need to be able to quickly determine - and with as little losses as possible - whether they have made a mistake. The use of technical indicators and charts can help to open trades at market tipping points, where a bad trade is much more likely to occur.
• Avoid mechanical errors. It's amazing how new traders (and even some professional traders) often make mechanical mistakes. For example, they buy when their intention is to sell, enter orders at the market price when they want to enter limit orders, or they open a position with 10 lots when they want to open a position with 2 lots.

We hope that these basic ideas will help you. There is so much more to learn, so before you take the big leap, find a way to learn that doesn't involve the risk of losing lots of money.