Hedonic Adaptation

Have you ever been sitting in a trade, everything is going great, your in the green with good profits, targets reached and you think “owww it might keep going further, I’ll hold on a little longer” only to have the trend reverse and then watch your profits disappear?…….. Yeah it happens to everyone.

This can happen on both shorter time frames, like day trading and longer time frames whilst riding parabolic trends or swing trading. You may enter a trade with the expectations of say 10 or 12%, however when it gets there, because everything is going to plan, you start to shift the goal posts and feel like you can squeeze a little bit more out of the trade.

As humans we have a very hard time controlling our emotional decisions, especially when it comes to our finances. Even more so, we have a terrible ability to predict our future emotions or how we may feel or react when we reach out desired goal.

We often refer the cause of this as our own greed, and it may be true to a degree, but there is a little more to it on a deeper level which is known as Hedonic Adaptation.

What is Hedonic Adaptation?

Hedonic Adaptation or more often referred to as the Hedonic Treadmill, is the tendency of a person to remain at a relatively stable level of emotions despite a change in fortune or an achievement of a major goals.
If you have a significant change in your lifestyle that enhances your happiness, like for example a pay rise, over time you will adjust to these changes, they will become the new norm and you will stabilise back to the same level of happiness you had before. As a person makes more money, their expectation and desire rises in tandem, so the rise in income results in no permanent gain in happiness and they desire more money to maintain that level again, almost like a drug addict chasing that next hit.

The same can be said about more unfortunate events, if something bad was to happen, like say a pay cut that reduced your happiness, you may feel temporary sadness but eventually these changes will become the new norm and your level of emotions will stabilise again. Another great example of this, is people who win the lottery tend to return to roughly the same level of happiness after the novelty of the win has worn off.
Some even end up less happier than before because the changes in personal relationships that occur or financial issues from miss management of there money. There is often an influx of joy as they make rapid changes to there lifestyle but after about a year or so when their emotions stabilise they can not sustain the lifestyle or have the ability to acquire more as they desire.

How do we combat this?

Awareness and discipline, If you have rapid growth in your account, your emotions are going to be well above a stable level and your most likely to make poor decisions, like risking to much on a position (cause you think you’re invincible) or holding onto trades for to long and start to go backwards. When your account takes a large hit and you end up in a draw down, your emotional levels are well below stable and you’re more likely to make bad decisions like doubling down on losing trades, or revenge trading because you believe the market owes you something.

Simply being aware of your emotional state can make a huge difference. If you have a big win or are on a winning streak, be aware that your emotional state is going to be above normal and it could influence your choices in the next few trades, so take a small break, reflect on your wins and give your self some time to adjust again.

The same can be said for a large loss or a losing streak, this will also require discipline. Being disciplined to stick to a trade plan is a key part to smoothing the curve of your emotional state. If your expectations have been met its time to exit or manage your trade accordingly.

Its worth noting you don’t always have to exit or close the position, there are ways you can manage your trade to ensure the risk is reduced by either raising stop losses or possibly closing a portion of the position. By taking these types of measures, your emotional state will stabilise by reducing the chance of loss or lowering the expectations of the potential outcome from the trade as anything from here on out is only a bonus.

Avoid rapid changes in lifestyle and frequent rewards for yourself to avoid volatile swings in your emotional state. Its also quoted that “the joy of giving, lasts longer than the joy of receiving”, donating a portion of your monthly income to a charity or someone in need can be a great way to enhance your happiness with out the desire for more, this theory is adapted by many very wealthy people and even some religions like Buddhists.

How to use this to your advantage

Part of the reason its often quoted to use smaller risk and build your account up over time, is because those small increases make it much easier for you to adjust your emotional state and not effect your decision making along the way, this is known as Conditioning.

You may not notice the small increase in your account on a day to day basis because the increases are small and have very little effect on our minds, allowing us to continue to trade in the zone.
If you have read the book by Mark Douglas “Trading in the Zone” you will know exactly what I’m talking about, this zone or frame of mind is where we are most efficient at our decision making.
By being aware of this phenomena and your current state of mind you can remain in the zone as much as possible making the best decisions and sticking to your original trade plan.

Take your time, its not a race.