Here’s a little thought exercise for you – think of the last book you read. Got it? Now try to remember the specifics of the book. Chances are that as you try to recall the specific events, you might remember the beginning but then the middle turns to mush, opening up to a much clearer ending. This is because for tasks that take our brains a long time to process, we generally come out best remembering the ending. In psychology, this is referred to as the recency effect.
When we apply this concept to trading, the recency effect is a mental state in which traders give more weight and power to their recent trading patterns. This weighted view of recent history leads traders to expect similar outcomes to reoccur. For example, if you put a trade right after a recent trade was a winner, you will be loaded with more confidence towards your next trade. This confidence will propel you to more easily enter the market.
On the contrary, after a recent loss or sequence of losses, your confidence will be weighted to the negative. There’s a good chance you’ll dwell too long on your next trade, worrying it will be a loss because your most recent trade was a dud.
Being aware of the recency effect is extremely important in order to build the self awareness to know what’s going on in your brain as you approach each trade. Imagine you’re a robot and you have no emotions towards your trading. Each trade you come to will be based on analysis, free from emotions, regardless of what has happened in your past. You would not be overconfident and jump in to the market too quickly, and you would not be less confident and rethinking your entry or past mistakes.
But you’re not a robot and therefore you’re going to be subjected to emotional whims. Like we said before, if your recent trading history shows success, you might be more confident and enter the market prematurely. Maybe you’ll add more to your position and risk more because you’re riding high on a confidence wave. But if you’ve recently had a string of losses, you might cut your trading size down to a fraction of what it used to be. This emotional rollercoaster will undoubtedly effect whatever potential profit there is to be had.
Being affected by the recency effect is going to affect your potential profit and your stable trading habits in a way that your growth or a decrease in your account equity will not be well controlled. If you come into the market after a sequence of losses and you reduce your position size but you happen to win, your profit will be less than it would have been before your negative confidence convinced you to make the drastic reduction. Your overall experience is still going to be that you haven’t recovered enough from your losses. Your experience will still be stuck on a negative emotion.
If you had a winner and you were putting more in and risking more and it ended up being a loser, you’ve suddenly lost all of your good efforts from the past. Your experience will be negative because you lost all of your hard labor.
Excessive Confidence In Either Direction Is Trouble
As we just explained, every time you’re affected by the recency effect, and you take action combining the confidence that you’ve built up, in both cases it may cause you to have a negative experience. At the end of the day you won’t be satisfied. Over confidence from recent success leads to neglecting planning and strategy, and low confidence from recent losses causes hesitation which might mean missing good opportunities. In both cases you don’t follow your trading guide because emotions have poisoned the process.
Being aware of the effect is one step towards resolving the problem. Once you know you’re affected by it, you can force yourself to be more loyal to your analysis and to be more faithful to acting on what you actually see in the market, not what you feel. It’s very easy to say this but it’s very hard to practice. When you’re flooded with emotions, your mind is not free to self analyze.
One Simple Question
One great tool to help you overcome the recency effect is to ask yourself one basic question right before you enter your next trade. Before you jump into the trade, ask yourself “what am I feeling regarding my prior experience?” Do I feeling confident, negative, positive, etc. The answer to this basic questions will guide you to your current mental state. Write the answer down and place it in front of you. Stare at it and become fully aware of the feelings your currently experiencing.
Once the note is unavoidably staring back at you, you should know where things stand, and therefore how to handle it. For each emotion, map out what actions those feelings lead to. For example, confidence might lead to rushing and discarding analysis, while shame and self doubt lead to possibly missing the next great opportunity. If you know the consequences to your emotions, you’ll know how to adjust in order to avoid them. Emphasize to yourself what you need to work on in order to confront your emotions.
This useful tool will help you adjust your decision making skills in order to incorporate your emotions without letting them dictate your actions. It’s important to note, however, that in the solution we suggest, it’s not advised to try to avoid your emotions and disregard them entirely in your decision making. The solution laid out here is based on understanding that you’re loaded with emotions and the only thing that matters is knowing how the emotions will affect your decision making. Learn how to tweak your brain in order for it be able to work with these emotions. As much as we’d like to be robots while we trade, no matter how hard we try, we’ll never be able to totally separate our emotions and feelings from our thoughts and actions.