Struggling With The Market? Try This Mental Trick

The psychological basis for most technical analysis is that investors have an emotional reaction as their gains or losses increase or decrease. The manner in which someone reacts to a stock they are holding with a large gain is very different than how they react to a large loss. The average trader is more inclined to sell a winner and proclaim victory than they are to sell a loser and admit defeat. That tends to be the wrong decision, but emotions, not logic, drive the decision.

Another simple example of emotions and charts is resistance levels. When someone holds a stock with a big loss, there is a greater likelihood that they will sell when the stock bounces back, and they are close to a breakeven point. Those breakeven points are resistance. Investors are just happy to be rid of this miserable stock that caused them to lose sleep. The reason they bought the stock in the first place no longer matters.

There are many variations of how emotions drive chart patterns, but the most painful situation for investors is when they continue to hold a stock with a big loss for long periods. There is often an inclination to do nothing. They want to ignore the issue rather than deal with it. Rather than just admit a mistake, the default reaction is to freeze and let losses grow too large. As the emotional and financial investment in the stock increases over time, it becomes extremely difficult to take action. Inertia sets in, and there is a tendency to believe that it is too late to take action.

Over time, many investors end up with portfolios that are littered with stocks that are acting poorly, which just sit there and eat up their capital and emotional energy.

So, what do you do? How do you get back on track?

The first step is to forget your entry points. Forget the fact that you are sitting on some big losers. Whether you have a gain or a loss doesn't matter. Start the day as if you just bought the stock that morning. Look at it as a brand new position, and make sure you do your homework and understand why you are holding it.

The next step is to develop a new trading plan. You have a new cost basis with no gain or loss, and that is your starting point. The problem with the stock started because you failed to manage the position effectively. You failed to cut it when you should have, or maybe you were just a victim of surprise news, poor market conditions or bad luck. It doesn't matter. Those things are all irrelevant, starting this morning.

You are going to have a new plan for managing the stock, and it will ensure that you will not let the loss grow beyond a certain point. You will stay disciplined and make sure you react immediately as conditions shift.

Technically, this approach is called mark-to-market. Your original entry point is irrelevant, and your new cost basis is the market price starting that day. Forgetting what you paid for a stock isn't an easy task, but it is the key to looking at a stock in an objective manner. If you have been holding a stock for a while and are sitting on a fairly-sizable loss, your emotional reaction is going to overwhelm your objectivity. You have to consciously suppress those feelings and stay very objective in your analysis. As a practical matter, the price you pay for a stock really is irrelevant. You can't go back and change that price, so there is no value in dwelling on it. What you can do is make decisions today, and you will make better ones if you aren't saddled with emotions. It is easy to understand why you are hesitant to deal with a stock that you have been holding for a while. You don't even want to look at it as it just reminds us of your mistakes.

Inertia in decision-making is probably what hurts investors and traders more than anything else. It is imperative to force yourself to make decisions about your stocks on a regular basis, and you do that by marking to market and looking at the situation with fresh eyes. Quite often, doing nothing is the right choice, but you have to make that decision consciously rather than let it happen by default.

Good investing and trading require patience, but that doesn't mean inertia and inaction. Mark your stocks to the current price, forget your entry points, and then force yourself to make decisions about whether to buy, sell or hold. Removing emotions from your decision-making isn't easy, but it is in your power to do so if you choose.

At the time of publication, DePorre had no positions in any securities mentioned.