We all know that making a trade is not free – it costs money (transaction, holding costs) and time (research, analysis, trade execution). But less commonly mentioned is that trading/investing also incurs emotional costs. Stresses are incurred in almost every trade, and it is important to take this into account in order to maximize the probability of success for your trading/investing strategy.
The market has been in chaos during the past week (as of the time this article has been written). Equity and crypto markets have dropped sharply, with some assets down as much as 50%. This is most likely the most stressful period for traders and investors since the Covid crash of March/April 2020. It is periods like this that the emotional costs of trading/investing become most significant, and hence most important to manage.
What is Emotional Cost
Emotional cost of trading/investing is the collective set of negative emotions one experiences during trading/investing which causes psychological stress and may potentially lead to emotional exhaustion.
Why It Is Impossible To Avoid Incurring Emotional Costs During Trading
Emotional costs are incurred whenever a non-optimal trading/investment decision is made, as regrets are experienced for every buy or sell trade which did not result in the most money made or least money lost. It is nearly impossible to consistently make optimal decisions in trading, as trading is too complex. To make a trade in general, one has to decide on 3 things:
- Direction of trade (Should I go long or short?)
- Timing of trade (When should I make the trade?)
- Quantity of trade (How much money should I put into the trade?)
It is literally impossible to consistently buy/sell at the absolute lowest/highest points using 100% of your buying/selling power. It is not necessary to do that in order to be profitable, but even when you have made a profitable trade, you would have some regrets over the decisions you could have made to make even greater profits. Indeed, there would be regrets in most trading situations.
For example, the regrets after a trade has been initiated are:
| Price went down after trade initiation | Price went up after trade initiation | |
| Shorted using 100% of selling power | No regrets | Should not have shorted |
| Shorted using < 100% of selling power | Should have increased position size | Should not have shorted |
| Didn’t initiate trade | Should have shorted | Should have longed |
| Bought using < 100% of buying power | Should not have bought | Should have increased position size |
| Bought using 100% of buying power | Should have bought | No regrets |
In most situations, regrets would surface. And it is unfortunate but true that the negative emotions aroused by bad trades are stronger than the positive emotions evoked by good trades. Thus overall, an investor/trader would likely experience net negative emotions from trading/investing.
Impact of Excessive Emotional Costs
Firstly, it impacts your trading/investment performance. Staying disciplined and sticking to your trading strategy is difficult when you are facing massive losses. Huge losing positions may be liquidated, even if they should be held due to fundamental/technical reasons. And worse, subsequent risky trades may be undertaken to try to recover losses, even if the risk/reward ratios are not favourable.
Secondly, it affects your mental well-being and may blunt cognitive capabilities. This would lower success rates significantly.
Lastly, there may be detrimental effects on the non-trading/investing aspects of your life. Your personal and professional life may suffer, perhaps permanently and significantly.
How Should You Manage Emotional Costs
The best way to manage emotional costs of trading/investing is to simply take them into account when deciding to make a trade. This should be done at both the individual trade position and entire portfolio level.
individual position level
- Max Loss
- Determine the lowest price your stock/asset would go to (or highest price, if you are making a short trade)
- Calculate the amount you would lose at the lowest point
- Decide if you can take the loss for that trade/investment position
- Daily Volatility
- Estimate the daily fluctuations in value of the position you are considering to take
- Decide if you can withstand the daily fluctuation in your position value
Portfolio Level
- Max Loss
- Estimate the losses your portfolio would take in the event of a worst-case market development
- Add the max loss of the position you are considering to take to your estimated max portfolio loss
- Decided if you can take the max loss for your entire portfolio
- Daily Volatility
- Estimate the daily fluctuations in value of the position you are considering to take
- Add the estimated daily fluctuation in value of the position under consideration
- Decide if you can withstand the daily fluctuation in value of your portfolio
Conclusion
The emotional aspect of trading/investing is generally under-appreciated in mainstream educational media. More coverage is placed on how to execute wining strategies and choose winning stocks. When positions are small, emotional costing may not be so significant, but it needs to be considered as soon as you start to increase position sizes. This would ensure that trading discipline can be maintained and cognitive performance is not degraded, and hence success rates can be maintained.