“Cut your losses quickly and let your profit run!” This is perhaps the most hackneyed phrase which is known to every investor and trader on the street.
But this simple sounding rule is most difficult to follow. Why it is so difficult for a trader to get out of a losing position even if it is way below his buy price and why it is so difficult to sit on profit when his stock is moving in right direction.
The answer is hidden in our own psychological phenomenon known as cognitive dissonance. This psychological phenomenon can lead a trader to make irrational decision.
In late 1950s Leon Festinger propounded the theory of cognitive dissonance. As per Leon, cognitive dissonance is a state of psychological imbalance that occurs when contradictory cognitions intersect. This contradiction creates a feeling of discomfort. In order to avoid this mental discomfort, we rationalise conflicting thoughts and try to harmonise mental discord to have a unified view. This strong urge to get rid of cognitive dissonance can give rise to irrational and sometimes maladaptive behaviour.
We keep rationalizing to deal with our cognitive dissonance in our daily life but this phenomenon takes a shape of problem when in order to reduce contradiction we get into self-deception. This is even more detrimental to traders who experience unpleasant emotions because of adverse market movement.
For instance, a trader buys a stock expecting it to go up based on his technical indicators, but when tide turns he is unable to get out of his position because his self-concept of being a smart trader might be under attack and to rationalize his position not only he keep holding his position but he adds on or in street parlance averages his positions. He starts concentrating on selective positive news and data and on the other hand he ignores bad news and views about the same.
Thus, it is very important that a trader understand his behavioural pattern. The understanding of his behaviour can help him improve his behavioural performance which in turn will help him improve his trading performance.
To deal with cognitive dissonance, one should follow strict discipline and trading framework . When traders follow ristictive trading framework they don’t act for emotional reasons. They simply follow their trading framework and act as per their indicators. Rule based trading framework helps traders in having an unbiased and free from any kind of cognitive dissonance decision making system.