Psychology and Risk Management
• What to expect
• Risks
• Position sizing
• illusion of control
• Accepting critisism
• Paralyzed by fear
• Loss is a feedback, not a failure
• The flexible trader
• Focusing on the positive
• Short straddle
• The dynamics of greed
• The herd mentality
• Notes
The Herd Mentality
Have you ever enjoyed watching a herd of cattle graze in a wide open field? It’s very amazing. As they graze and stand in a dispersed pattern, the cows appear content. One cow suddenly decides it has had enough food and begins to move toward the barn without giving any obvious explanation. The remaining cows all appear to follow, one by one, until the entire herd is moving directly toward the barn. Where is that man going, the cows seem to be wondering. What is he aiming for? I’d like to participate in this. I’m going to go after him. Despite the fact that the leader does not appear to know what it is doing, they nevertheless follow it.
That is a stark illustration of the herd mentality, which some market experts believe to be similar to the markets. One trader begins to buy, followed by another, and so on until a number of traders are all making purchases for no apparent reason. Despite having a higher level of intelligence than cattle, people have a natural tendency to follow the herd. Everyone seems to be thinking, “These people can’t all be incorrect,”
Going with the flow makes sense in some situations. In a bull market, buying and holding makes logical because rising prices are anticipated. However, if market circumstances change, you must be cautious to avoid getting crushed by the merchants at the back of the herd as you try to stop to avoid running into a brick wall. The mob is usually right up until a turning point occurs. Why? Once practically everyone has determined the market is headed in one direction, there aren’t many traders left to sustain the trend.
At that point, a countertrend starts and the market starts moving the other way. The trick is anticipating that turning point, knowing when it will happen, and creating a trading strategy to profit from it. Humphrey Neill describes how to adopt a contrary viewpoint in his book, The Art of Contrary Thinking. Having a different viewpoint from everyone else entails more than just going against the grain. A true contrarian uses creative market analysis to try to come up with a novel trading strategy. It necessitates extensive knowledge and consideration. One must develop the ability to think counterintuitively to the dominant wisdom. It resembles thinking backwards in several ways. Consider the probabilities that the audience is mistaken.
Look for indicators that could signal a change in the market’s dynamics or uncover new industries that might profit from the change.
For instance, during the Great Depression, many favoured staying in and listening to the radio to going out to watch movies or live performances. As a result, radio stations turned a profit during a difficult economic period. Such chances are discovered by a contrarian, who then seizes them.
Although taking a contrarian stance might be helpful, it can be challenging to overcome the herd instinct. People naturally have a tendency to watch what others are doing and follow suit while investing. It seems secure and cosy. However, if one is not careful, going with the flow might be disastrous. The majority may not be right. Therefore, constantly consider the alternative. Analyze the markets thoroughly. Think about the reasons the majority might be incorrect. Look for evidence to bolster the opposing argument. If you are correct, you can profit from it and achieve a significant victory.