Shrink Rap: Remove the Fear Factor From Your Trading

Dr. Hendlin, I am primarily an intermediate-term investor, holding for a few weeks up to a few months and making about 40 trades per year. I'm wondering if my avoidances while trading are really fears that I don't label as such. Could you describe some of the basic fears you see operating with investors?

Shrink Rap: The following handful of errors are made primarily out of fear. While a lack of trading experience and certain personality traits may enter into the picture with these, it is fear that is most prominent in causing the problem. Notice which, if any, you identify with:

Paralysis through analysis. For some traders, especially among rather obsessive or timid types, the basic fear of committing funds to the market is the first hurdle that is tough to clear. The fear of being wrong comes through in procrastination.

Too much analysis may be displayed as the need for just one more piece of information, one more trial period to paper-trade the stock, one more earnings report or one more anything else that may be used to put off committing to a purchase. This need for more information may be played out indefinitely on the Internet, on which there are many stock sites that offer detailed company analysis and expert commentary.

Procrastination often has a way of backfiring, though, because it leads to exactly the assessment of having made a mistake, which is what these investors are trying most to avoid. Often, these investors will wait too long before entering a position and miss the greater amount of upside movement of a stock. Even worse, some procrastinators have a knack for buying near the top of a rally and then spending a long time struggling just to get even. For those who repeatedly notice that they enter a position too late, this fear of commitment to a position may be operating.

Afraid of pulling the trigger. This is related to the first problem. Sometimes investors know they want to buy and have completed their analysis but still have a problem actually entering the trade. They can't bring themselves to go ahead and pull the trigger. This may be experienced as trader's block, or freezing at the keyboard as they attempt to hit the "buy" key.

You might remember a couple of years ago this difficulty was made into a humorous commercial by E*Trade. In it, a rather young investor sits in front of his computer monitor with his index finger shaking over the mouse, but he's unable to click it to enter the trade. He paces back and forth across his room, does jumping jacks to deal with his anxiety and makes a number of premature passes in front of his monitor before he finally works up the courage to click the mouse button. The tag line was "Be not afraid."

I liked this commercial mainly because it was the first one by a discount broker that recognized a common problem of online trading, rather than just enticing everyone with the riches to be made during the height of "bubbleocity."

While the fear of execution is fairly common for many beginners, as well as those who have had a losing streak, it is not openly discussed. This commercial directly acknowledged that emotions and investor personality and temperament were part of the trading experience. And, of course, the fear of executing trades has been even more a part of the experience recently as a result of the prolonged bear market.

Afraid to sell when a trade goes sour. According to popular trading lore, this is the single biggest problem for traders in general. This includes daytraders and position traders, as well as long-term investors.

Selling a losing position requires admitting that we have made a mistake in judgment. Because this is tough for many of us to admit, we hold the position too long and lose more and more money as we ride the position down to the depths of hell. What is lost, besides further capital, is the opportunity cost of that money.

To bypass admitting to a mistake, while at the same time saving yourself the agony of a runaway loser, get in the habit of putting in a stop-loss order when you first enter the trade. Only experienced and disciplined position traders and scalpers should rely on "mental" stops to protect themselves. Otherwise, false pride, ego and wishful thinking will make it too easy to disregard the mental stop.

Afraid to assault the ego. I've mentioned previously that the psychological theory for the need to reconcile information that is inconsistent with our self-concept is called cognitive dissonance. This theory says that we want to reduce any contradictory information that clashes with a positive belief we hold about ourselves.

So the acceptance that we made a poor judgment by holding a stock too long is dissonant with our belief that we are good stock pickers. Traders need to be able to put their false pride and ego aside in favor of discipline. I know -- easy to say but tough to do!

Afraid to let profits run. This appears to be a rather common error. It is based on an overly conservative approach to profit-taking. We are happy to feel the pride of settling for a little profit rather than take a chance we may lose it.

For conservative investors who know the limits of their risk tolerance, this is the least noxious error to make. Especially if they have a preset amount (or percentage) of profit and they reach their goal, it is good discipline to take the profit and be content. This is the idea behind the self-evident dictum that "You can't make a bad trade when you take a profit." One way to deal with the fear of losing profit is to sell a percentage of it and let the remainder stay in play. This is a common strategy of money managers and savvy traders.