Psychological Analysis. Adam Sarhan

tulip bulbs diverged sharply from any rational evaluation. When you study history, you can clearly see that the assets changed, people, language, century, and just about every other variable changed, but the one constant was human nature.

SMART MONEY VERSUS DUMB MONEY

      It became clear to me that Selden was right. Not only did I agree that psychology had a significant impact on the “movement of prices on exchanges,” I took it a step further and decided that human nature (specifically, my thoughts and behavior) is the most powerful force I could control—and the best part is human nature never changes.

Markets are counterintuitive in nature, and the main reason is that humans, all too often, are intellectually lazy and prefer immediate results, they want a shortcut, they want the easy way out, and they do not want to work. The smart money does the opposite. They focus on the goal: winning. They know the work needed to win is just an inevitable part of the process.

      The dumb money loves drama; it loves being the hero of its own (usually dumb) story. Dumb money loves to play the victim card, find villains, and blame others for failure.

      Smart money does the opposite on Wall Street; we play to win, take responsibility for our actions, measure our results, improve our game, and focus on the next win. The dumb money runs away from pain and is drawn to instant gratification and pleasure.

      The dumb money chases shiny objects, is constantly tempted by greed, is crippled from fear, thrives on chaos, and clings to hope. It's always been this way. Human nature never changes.

      Put simply, people in the smart money circle are in control of their psychology—their thoughts, their decisions, their actions, their money, and their life. The people in the dumb money circle are not.

      Knowing that human nature never changes, and understanding that psychology affects the price for just about every freely traded market in the world, I began looking for evidence of human nature at play in stock charts. You see it when a price jumps on the promise of good news. It's there when institutional traders show up and support a stock that is falling. It's there when millions of traders jump to buy a hot new stock as it races impossibly upward, fueled by a fear of missing out or blind greed. You see it when the faint‐hearted abandon their positions the first time a stock falls a few points and they experience pain.

      Unfortunately, human nature is difficult to quantify. It's difficult to predict with an algorithm—just ask Google, as they spend unimaginable fortunes to unravel the mystery. Instead, human nature has a more intangible quality. You know it when you experience or see it. In time, with experience, the intangible qualities become obvious when you know what to look for—in yourself and in others.

THE INDESCRIBABLE QUALITY OF HUMAN NATURE

Don't believe me? Try this challenge: I will give you $1 million cash right now (in unmarked bills) if you can tell me what the color red looks like—to describe it in a way that someone who has never seen it before would instantly recognize it. Go ahead, I'll wait. How about this: describe what chocolate tastes like so that someone who has never tasted it will know it when it touches their tongue. Don't worry, I'll stop waiting. You can't because no one can. That is an example of an intangible quality in life.

      There are certain qualities in life that you have to experience in order to understand. It is impossible to explain what an intangible quality is because you have to experience chocolate to know chocolate. You have to fall in love to know what it feels like to be in love with someone else. It cannot be explained in words. But once you experience it, you know it. After you eat chocolate, I cannot give you vanilla and tell you it is chocolate.

      That's exactly like the intangible quality of human nature that I look for in stock charts, and although it's impossible to describe, I know it when I see it. That's one part of psychological analysis. This book is dedicated to helping you develop the ability to detect human nature in the market. We start by considering some basic questions:

       Why do you invest/trade stocks?

       Why are other people investing/trading?

       Why are you buying/selling?

       Who is on the other side of a trade?

       Why are they buying?

       What are they selling?

      These aren't questions you can answer with 100% certainty, but simply asking them will start making you aware of the presence of human nature in the market. Over time, you'll develop skills and an accurate feel for the market that will help you get in and out of positions before the crowd. It will become a priceless tool in your toolbox.

      To be clear, at first, most people have an inaccurate feel for the market and they should not trust their gut in the market. Why? Because their gut is not properly trained. The goal is to rewire your brain and train your gut so that it provides an accurate feel that can help you identify opportunities and avoid common pitfalls. That will come with time, experience, patience, many (hopefully small) losses, and many (hopefully big) wins.

What's more important than recognizing human nature at work in the market is recognizing human nature at work in your own trading decisions. Hope, greed, fear, pleasure, and pain are some of the emotions that affect our decision‐making (and almost never to our benefit). You can learn to use psychological analysis on yourself, and in time develop a state of mind that helps you rise above your inherent shortcomings, and learn how to do what Benjamin Graham, Warren Buffett, and countless other one‐percenters have done, and turn yourself into your strongest asset and not your worst enemy.

      It is important for you to know that, by no means, do I recommend that people trade by that “feeling” alone—it is simply a valuable skill to develop that can help you read the tape (a.k.a. the market) and complement your overall trading strategy.

      People ask me what my strategy is and I always say, “a rules‐based discretionary approach.” Meaning, I have strict rules for everything I do, but I use my discretion, informed by psychological analysis, when it comes to executing my trades.

      In a few chapters, I'll spell out my investment strategy, and then we'll explore how psychological analysis can help you establish the smart money mindset required to execute the strategy. Just like weight loss, trading is 99% psychology and 1% knowing what to do. Once you learn how to do this, you will be ahead of the crowd and well on your way to beating the market.

      First, however, I have to make sure you understand the basics of how the market works, and how traders and investors have traditionally used fundamental and technical analysis to inform their trades.

      Profits are a function of time.

CHAPTER 3 The One Question You Need to Ask Before Getting Started

      Markets are a meeting of the minds, and the smartest minds win.

       —Adam Sarhan

ARE YOU AN INVESTOR OR A TRADER?

      Many people use the terms “investor” and “trader” interchangeably, but there are very important differences. One takes a fundamental approach and is interested in the intrinsic value of an asset. The other takes a technical approach and is more concerned with the price. One thinks in the long term, the other in the short to mid term. Soon, you'll know which is which, but first, we have to explore a more basic question.

WHAT IS “THE MARKET”?

The best investors (and traders) in the world have clarity. They are focused, they know exactly