On September 13, 1848, foreman Phineas Gage worked on the construction of a railway. Unfortunately for him, following an explosion, a meter long iron bar weighing six kilograms pierced his skull. To everyone's surprise, he came out alive! Additionally, at first glance, he did not seem to have any lingering effects from his accident. Although he had lost the use of his left eye, he reasoned, he expressed himself well and he suffered no paralysis. However, Phineas Gage was no longer the same. Previously regarded as caring, conscientious and polite, he was now unpredictable, vulgar and indifferent to others, making him unable to manage his money, maintain quality interpersonal relationships and maintain a stable job. How can such a phenomenon be explained?
In the 1990s, having re-analyzed this case and studying many patients with similar brain injuries, neuropsychologist Antonio Damasio found that the nerve centers for emotions had been affected, which prevented these patients from controlling their behavior and their decision making. For example, despite the fact that they could logically describe their actions, they were incapable of making decisions as simple as choosing a meal. In addition, without feeling shame or fear, they tended to ridicule themselves in public or engage in risky financial activities. For the first time, the role of emotions in the decision making process was recognized.
Trading success is explained 75% by state of mind and 25% by knowledge.
In light of the foregoing, reason and emotions are used together in making market decisions. This is why it is important to focus on three specific objectives: adopting a management method, risk management and self control.
No 1: Adopting a Management Method
Clearly, it is essential that you choose a methodology that suits your personality and personal goals in terms of performance, risk tolerance, investment horizon, and time spent actively trading or investing. To do this, fundamental analysis and technical analysis are an excellent starting point.
First, fundamental analysis aims to determine the intrinsic value of a stock by assessing the factors that affect the issuing company, such as the global economy, industry and financial health. If the intrinsic value is higher than the stock price, it is an opportunity to buy. As for technical analysis, it focuses instead on the behavior of market participants through a study of price charts and mathematical indicators in order to predict the progress of a financial instrument.
No 2: Risk Management
Regardless of your education, experience, past success or the quality of your investment philosophy, risk management remains crucial. Theoretically, since the price of a share can go to zero, it is essential to prioritize diversification and to maintain strict rules (for example, limit the weight of a security in the portfolio and provide for a maximum loss per position). By doing so, it is possible to guard against substantial stock market losses. In this regard, an analysis of the market activity of 8,000 discount brokerage accounts reveals that 21.5% of clients have never sold a share that had fallen below its entry price!
No 3: Self Control
Many people wrongly think that achieving the first two goals is a sufficient condition for success in the stock market. Unfortunately, this is not the case. If it were easy, everyone would do it! Given the ambiguous and uncertain nature of financial markets, it is relevant to limit errors in judgment related to information processing, memory, thoughts, attitudes and emotions. For example, according to Kahneman and Tversky, the psychological discomfort caused by a loss has an impact twice as great as the satisfaction of a similar profit. We therefore tend to forgo calculating an exit point in case of loss, a behavior which should be avoided. As in the case of Phineas Gage, self control is an indispensable skill.
If you want to deepen your knowledge of the subject and achieve your market goals, I invite you to register for training programs offered by Desjardins Online Brokerage.