Don’t just follow the crowd. Resisting social pressures

IG recently conducted comprehensive research to uncover valuable insights into how psychology impacts real world trading decisions. Throughout the project, our experts studied the results of over 30 million closed trades across 15 markets, examined third-party academic studies, analysed data from multiple surveys and consulted with several industry thought leaders. The following article has been developed using insights gained from this research.

DYOR. Do Your Own Research. It’s one of the most frequently used terms in trading circles, and for good reason. No one should make trading and investing decisions without doing their due diligence - but it happens all too often.

In much the same way teenagers are famous for taking unnecessary risks due to peer pressure, traders can allow the opinions and behaviours of others to prompt them to make unwise decisions. Being aware of how social pressures can influence your mindset is an important step to avoiding costly mistakes, so read on to discover how social pressures like herding, rumours, news and competition can affect traders’ behaviour – and how to prevent them from leading you astray.

Herding

What does 'herding' mean in trading?

Herding in trading is the tendency for traders to follow others without doing their own research and analysis. They will observe that there is a trend among other traders, and then feel the pressure to jump on the bandwagon, even when there is no clear reason for them to do so.

This behaviour is often driven by fear and greed, as traders don't want to miss out on opportunities that others are seizing. However, basing decisions on herds inhibits learning and can lead to information processing errors.

Research by Kremer and Nautz stated that herding can lead to bubbles and crashes if trades are not based on analysis¹. An example of herding can be seen in the 1990s to 2000s dotcom bubble. Traders were all buying into the market, because 'everyone was doing it', but then the bubble burst and many people suffered severe financial consequences.²

How can traders prevent herding?

The first step to preventing herding is to make decisions based on your own trading plan and research.

Although social trading is becoming increasingly popular, it's important to be mindful of your personal plan, and not just do what others are doing for the sake of it. This is why many traders set SMART goals to keep themselves focused; these are goals that are Specific, Measurable, Attainable, Relevant and Time-bound.

Remember, financial markets can be unpredictable – so it’s important to stay up to date and do your own research.

Rumours

How do 'rumours' affect traders?

Rumours in trading are any type of unverified claim that can influence traders' decisions. Rumours can cause traders to make mistakes by influencing them to enter and exit positions based on fear and greed rather than fact.

Rumours can be favourable or unfavourable towards a financial asset, which can cause traders to either buy the asset or sell it prematurely. For example, in 2002 there was a rumour that United Airlines was entering bankruptcy, which caused the company to lose 73% of its market capitalisation. However, this rumour was false. A study by Marshall found that although participants were aware of false information, they held their positions for twice as long as expected.³

According to IG's survey, websites and news reports are traders' most popular sources of information – potentially making them susceptible to rumours.

How can traders avoid rumours?

It's impossible to avoid rumours or fake news completely -- they're everywhere -- but traders can control how they react to them. Markets can become extremely volatile when a rumour is spread,
so it’s important traders remain as rational as possible and always consider the risks when trading.

Widely reported rumours can have their place in fundamental analysis, but you should always assess the source and reliability of the rumour carefully, before factoring it in, and have a risk management strategy in place. With a risk management plan, you can set stops and limits to prevent larger-than-expected losses, as well as trading alerts that give you a choice of whether to act or not.

News

How can the 'news' affect traders?

The news can put pressure on traders to make certain decisions and interpret information in a particular way. News is a crucial part of information gathering, but it's important for traders to interpret the news objectively.

Forsythe, Nelson, Neumann and Wright studied 192 traders' opinions on US elections and found that the individuals who dispassionately interpreted the news and resisted confirmation bias were more likely to make a profit⁴. In contrast, those who traded the news and exhibited availability bias became overconfident, and this increased their risk.

How can traders use financial news?

Using financial news is a great way to stay abreast of changes in the market and help you fine-tune your strategy, but it’s important not to become over-reliant on one source as this can create a narrow view of the market.

Fundamental analysis is the gathering and use of various internal and external factors – like news, macroeconomic data and company announcements – to decide how much a particular asset is worth.

However, it’s also important to use technical analysis too. This can help you predict the future direction of a market's price by studying historical chart patterns and formations. It involves applying technical indicators, such as Fibonacci retracements and moving averages, to identify price patterns and key levels.

Competition

How can 'competition' affect traders?

Competition is the pressure to make more money or place more trades than others. While trading is considered a competitive practice, traders should have the patience and discipline to follow their own trading rules and plan.

Competition can cause a trader to adopt bad habits – for example, a 'win at all costs' mentality, which could open them up to negative emotions and impulsive trading decisions. A study by Dijk has found that traders put up 50% more in a risky situation when peers would be aware of their decisions than when they were in an isolated individual setting.⁵

Not only should traders be wary of competing against each other, they also shouldn't compete with themselves. By trying to beat a record or increase a profit every day, traders might be forcing themselves into trades they wouldn't normally make.

How can traders avoid competition?

To avoid competition, you can create a routine based on your trading plan and risk management strategy. One popular tool is a trading diary, which helps you keep record of your trades – including why you entered them, the expected profit, how you chose to minimise your market risk, your entry and exit points, and how the market behaved.

You should focus on yourself, as there is more potential in self-development and learning than there is in competing with others.

Footnotes:

¹Kremer and Nautz, 2013
²CFI, 2019
³Marshall, 2009
⁴Forythe, Nelson, Neumann and Wright, 1992
⁵Dijk, 2016