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The Psychological Effect of Volatility in the Markets

Psychology plays a huge role in the stock market. I am referring to internal psychology, not about the whole global market psychology. Your emotions will dictate your risk tolerance and that’s through experience and being in uncomfortable situations that will help you be a better trader. I am talking about being uncomfortable when you have anxiety to actually go through and act on something. The more you face and move past anxiety, the more you will grow your comfort zone, and therefore help your trading. For example, a common thing that always brings anxiety to most is to see their ex-girlfriend or ex-boyfriend soon after the breakup. If you can handle this fine, move on to something that you have even more anxiety about. It will grow you.

In the stock market you have volatility (fluctuation or variation in price). Sometimes this volatility is very minimal where a stock can jump just a few pennies in a minute, other times its so extreme that certain stocks jump $2 within a blink of an eye and then bounce back up. Beginning traders often believe that they can handle more volatility than they actually can.

Lets take Joe, an new trader who has $10,000 in stock XYZ @ $50 / share. (That’s 200 shares). Joe says that he can handle a 20% drop (meaning $8,000 in value or $40/share). It doesn’t sound bad on paper, but what happens in real life when the numbers and ticker tape actually starts rolling is that by the time the stock is at $47 the mind is starting to ask questions. Doubt is starting to set in. At $45/share Joe panic may start to set and Joe may end up getting out. The stock can reverse back and soar past $55/share. Even though he said his initial tolerance was much more, the actual risk tolerance in the situation is far less. Knowing that only comes from experience.

This happens often for beginners. Most beginners do not know how to handle their emotions or block out the noise of information that is being fed to them. That’s why panic starts to kick in, they sell too early, or they sell too late in hopes of the stock going back up.

The point here is that volatility in the stock market can play a huge role in your decision making process. So make sure you learn about your internal risk tolerance level and experiment with it. The best way to do that is to invest real money, but to only invest in 3 or 5 shares. Yes you will lose out on commission, and probably not make any money from the trades at all, but you will get real money experience and real emotional experience without large losses.

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