Psychological Mistake #1: The Need To Be Right

Ever since we started going to school, our educational systems have almost always measured our success based on how often we are right. In all the examinations, the number of right answers we give determines our grades. As such, we live in a culture that thrives on being right as often as possible. We have been taught to not make mistakes. Being right has almost become a necessity, because it seems to be closely tied to how we are being measured, and our egos seem to be at stake when we make major decisions and are judged based on how right or wrong these decisions turn out to be.

Such a psychological "need" becomes even more apparent when we make financial decisions. Perhaps this is because we live in a money-saturated culture that often measures our worth based on our financial status. When trading the Forex market, this psychological need is, very often, counter-productive to our trading success. This "need to be right" is rooted in the fact that humans are driven by instant gratification, i.e. we would like to experience the immediate joy of taking a small profit, and delay the pain of taking a loss.

Just imagine that you are given a choice between the following two scenarios. Which would you choose?

1. A sure loss of 20%, or
2. A 5% chance of no loss at all, plus a 95% chance of a 25% loss.

Most people will prefer the second option. This is because most people naturally refuse to "cut their losses short". Taking the second option (which is actually more risky) implies that people naturally hope that losses will stop and that the market will turn back in their favour. This causes people to hold on to losses even when the market does not turn back.

The psychological trap is such that the worse the loss becomes, the more unwilling we are to take it. Many traders are therefore ultimately being forced to take the loss when it becomes too painful. Instead of losing a mere 3% of their account balances, they end up losing 20%, 30% or even more. If the trader has been "discipline" enough to take that 3% loss based on a pre-defined exit point, he would have been able to catch profitable trades in the opposite direction when the price continued downwards.

Consider another similar scenario, where you are given a choice between two options as follows:

1. A sure gain of 20%, or
2. A 5% chance of no gain at all, plus a 95% chance of a 25% gain.

Which one would you go for?

If you are like most people who do not guard themselves against human psychological biases, you will choose the first option this time, i.e. you would prefer to take a sure gain, rather than to take a risky bet for a greater gain.

Once we have a sure gain in our hands, we tend to be afraid of seeing the profits disappearing away. We take the profits at any signs of reversals, even when our trading strategy has not given us an exit signal. By developing a habit of taking profits too soon, i.e. before the pre-defined profit target is reached, we end up short-changing ourselves in the long term.

So, what do the two scenarios illustrate?

The first scenario illustrates how we tend to be more risk-seeking in losing positions. While hoping that losses will turn to small profits or even just reach the break-even point, we are willing to see losses become bigger "for the time being". This behaviour is rooted in a psychological need, for it delays the immediate pain of taking a loss.

The second scenario illustrates how we tend to be more risk-averse in winning positions. We are afraid to see profits disappear, and are unwilling to "take the risk" to maximise our profits when strong trends are identified. This behaviour is rooted in our need to immediately experience the pleasure of taking a profit.

Think carefully about what happens when you repeatedly allow these two scenarios to happen in your trading journey. Inevitably, you will realise that your profits are not going to be enough to cover for your losses in the long run. This is why some traders can have very high success rates, and yet end up losing money!

These psychological responses to winning and losing positions are due to our distorted need to be right in every trade that we take. For most traders, being right naturally means not losing money in the trade. If we do not consciously overcome such dispositions, we find ourselves driven by a very short-sighted desire to force every trade to be a winner. This is why many Forex traders often operate in a "fire-fighting" state of mind, constantly watching their positions and attempting to "salvage" every trade by ensuring it does not become a loss.

We need to understand that being right does not simply mean not losing money. Some losing trades can indeed be valid ones, whereas some winning trades can be "wrong" in the sense that they are based on rash guesses and bad risk management. Being short-sighted and trying to make every trade a winner (even when the market has invalidated the trade by turning against us by a certain amount) will do more harm than good in the long term. When we learn to think in terms of probabilities, understanding that they work out over a large number of trades, we become far more comfortable about taking a small loss, and then moving on to the next trading opportunity.