Overcoming Mental Accounting Errors

Mar 19, 2007: 9:57 PM CST

Once you understand how mental accounting errors can hurt trading results, it is helpful to identify patterns in your own thinking and trading which can be challenged with personal strategies.

While a blog entry cannot attempt to identify and correct these errors, I can challenge you to identify your own thoughts and seek out further resources to help you if you feel you fall victim often to mental accounting errors.

It is much easier to overcome the accounting error which is derived from windfall profits. Simply equate ‘free’ money with earned money and treat it like you would any other trading capital, rather than using it as an excuse to take that risky trade you have been eyeing. Be thankful for the profit, but consider pulling some out to treat yourself, rather than putting it back to work in a speculative play.

Most traders trade with scared money (money they cannot lose), and so that is the approach upon which I will focus.

First, ask yourself how you feel about money. Ask yourself what money means to you. Common responses include “power” “security” “authority” “happiness” “things/toys” etc. Now interchange terms: “When you are losing money, you are losing … power, security, happiness…”

Losing money you can’t afford to lose usually results in one of three behaviors:

  1. You are too scared to enter any further trades, and keep your money in cash
  2. You enter a trade, but cut it early when you have a very small profit and store the rest in cash
  3. You endure a small loss and hold on while the small loss becomes a big loss when you finally sell

As you see, mental accounting helps us understand why retail investors are much less likely to “let winners run and cut losers short.” It’s because they can’t afford to lose money and the perils of loss.

How should you view your trading dollars? When you first start as a trader, it might be best to view your account not as money, but as something entirely different, like poker chips or “play money” or whatever works best for you to detach the mental link between your trading capital and the efforts required to achieve that capital. Do you think casinos would be as profitable if we used real dollars to make bets? They manipulate the psychology behind this concept.

You need to focus on the process and structure of trading and following rules, rather than the emotions of having money on the line.

Sometimes, it is best to view that money as “spent money” on education. It has been said many times “only trade with money you can afford to lose” and so why not “mentally account” for the fact that it is already gone? Any time you take a loss, it doesn’t matter because you’ve already “mentally” lost the money. Any profits will just be wonderful and will beat expectations (profit, of course, is your goal – do not ‘expect’ to lose when trading).

Business owners turn money into products and inventory, and it would be rather foolish to imagine them thinking like some traders do. “Ohh, I can’t buy this or that product because no one will buy it and I might lose money.” Picture yourself like a business owner – your capital becomes products (shares of a company) that you hold for a bit (but without spoilage or warehouse/stocking fees) that you will in turn sell to others who want what you bought earlier (hopefully at a higher price than you paid). Deeply envision this so that you de-link the association between money in trading.

Money becomes a vehicle to make more money in the market. Be glad that, as a trader, you do not have expenses such as advertising, stocking, inventory, rent (for a business), etc. Of course, your losses can be “mentally accounted” for as normal operating expenses, to further the analogy, which puts you back on par with the business owner example.

  • Find a way to disassociate your trading account with your money in the bank account.
  • Find a strategy that is personalized that works for you.

Your goal in trading is to establish a tested strategy, employ proper money and risk management, and follow a code of behavior/action (discipline) that is personalized for you and tested by you. Decisions regarding when to enter, how long to assume risk, and when to exit must be made by your system – not by emotions or mental accounting errors.

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