Your mind is the most powerful asset you possess at any instance. It doesn’t matter how many trading tools and aids you have on tap, if you are unable to engage your mind in any constructive market analysis, trading won’t benefit you.
However, we humans don’t make the right decisions all the time. Most times, we are plagued by cognitive biases that impede our thought process and ultimately result in a flawed decision-making process. The result, especially when it comes to trading, is a loss of vital profits.
Cognitive biases in trading is not a new phenomenon, and traders have had to cope with this limitation for ages. Cognitive biases are a human characteristic and as long as we remain so, we won’t be able to overcome the flaw.
However, knowing the effect of these biases on our daily lives is as important as solving the problem itself. Therefore, this article will break down a couple of cognitive biases traders have to contend with daily. Moreover, this article will also show you how to remedy some of these biases and aid in successful trading.
1. Confirmation Bias
Human beings are notorious for practicing favoritism. That is why a lot of people only listen to the opinions and sentiments of those who favor their point of view. The same occurs in trading whereby the confirmation bias compels us to agree with information that only supports our case.
This cognitive bias is harmful to your trading prospects since you are going to consider very little information before arriving at a decision. On the other hand, you need to gather extensive data to trade successfully.
Also, the bias forces our personal opinions and individualism to get in the way of profitable trading. While looking for information about the market, traders will tend to skew their search to get favorable evidence as opposed to objective data.
The global market is affected by several factors. These normally dictate the pace of trading and further affect how the market behaves. If you tailor your analysis to only consider one or two of these factors, you would be assuming the others hold no sway in the market.
This type of selective thinking is compounded when you only consider very little data. So traders need to realize that objectivity while trading is paramount. The market is an independent entity; it doesn’t care what you think to be true so keep your prejudices away from the trading floor.
Always be on the lookout for new information. The influential English economist, John Maynard Keynes, once quipped, ‘When the information changes, change your conclusion.’
2. Anchoring Bias
Cognitive biases manifest in different ways, more so when it comes to accepting new information. Traders will often anchor their decision on the first information they received.
There is no problem with believing legitimate information. However, doing so puts too much weight on it such that you tend to block out dissenting opinions.
The market is the primary source of trading information, and traders are keen on price changes and the general trend. So when a market starts off the day with a robust bullish direction, a lot of people will likely believe this to be the trend throughout the session.
However, they fail to ignore that this was just the first signal from the market—everything else after it doesn’t matter. So if the trend reverses over the course of trading, you can guess who will lose out.
Many cognitive biases seem to inhibit traders from getting a broader picture of the market. The anchoring bias similarly makes traders fight the market because they believe what they know to be true. Stubbornness enables anchoring bias and if you want to be rid of this bias, then practice some flexibility.
Ideally, you would consider past data so that you get a bearing on what the market is doing. Also, take into account new information. You have to be in the know while trading. Therefore, lose that anchor that is leading you blindly.
3. Gamblers Fallacy
Gambling and trading are somewhat interlinked. Sometimes trading is mistaken for gambling owing to the need to make predictions. Traders routinely carry out analysis in a bid to foretell future market behavior.
However, they are two different pursuits. Trading, on one hand, represents a measured approach to making money. Most times, gambling is often a result of one’s gut feeling and a large majority of gamblers rarely analyze their picks. If you apply this thinking to the trading scene, then get ready for monumental losses.
That said, the Gambler’s Fallacy shows a flawed analysis of probabilities. Traders, like gamblers, are inclined to believe that a previous series of events have an effect on the future and tend to influence what will happen at the time. While this is true, future events are, however, independent in their own right and not tied to what happened yesterday.
The Gambler’s Fallacy originated in Las Vegas during the early nineties. It was at this point that it gained its famous moniker, The Monte Carlo Effect, from the casino by the same name.
On a roulette wheel, the ball fell on black several times back-to-back, and from a gambler’s point of view, it would then fall on red given the numerous times it landed on black. However, it took twenty-seven turns to land red and along the way, millions of dollars of gamblers’ money went down the drain.
Another simplified example is the coin toss. If you flip a coin ten times and it always lands ‘heads’ side up, you might think that that result has occurred on too many times to repeat. So the eleventh toss will probably yield the ‘tails’ side up.
In any coin toss, the likelihood of a given outcome is 50%. This probability never changes because there are only two outcomes that can occur. So even if one hundred heads show, the next toss will have a 50-50 chance of being either heads or tails.
4. Post-purchase Rationalization
Once you make a decision, you tend to stick with it and even go on to rationalize the same. This way, we are convincing ourselves that regardless of the outcome, it was a well-intended move.
Traders are prone to post-purchase rationalization more so when it comes to risky and otherwise costly purchases. This is witnessed after traders have done extensive technical analysis and information gathering before trading.
Before entering the market, traders need to be constantly updated on the market environment. This necessitates long hours and a wealth of trading literature. So it only follows that once you settle on a trading move, everything will make perfect sense. Very few people will admit that making a wrong move, and this is often their undoing.
A failed trade remains so, despite how much you try to rationalize it. Sometimes when traders are buried in their analyses, they might overlook minor details that will eventually hurt their trade.
Once in the market, we become so convinced in the illusion of the ‘perfect’ trade, we are inclined to ignore red flags on the way to making a loss. Trading allows participants to salvage a losing move early on. Rationalizing a losing trade blinds you to the fact that it is failing.
After committing several man-hours’ worth of technical analysis as well as consuming a wealth of literature on the market to find the perfect trade, very few will admit to an error. Many will instead resort to post-purchase rationalization and, in the end, watch their effort go down the drain.
5. Loss-aversion
Everyone, including traders, likes to win. One of the primary reasons why people get into trading is to earn money. The prospect of turning huge profits motivates a lot of people to trade. However, on the flip side, it brings about the loss-aversion bias.
Encountering a loss is far more painful than the pleasure derived from a winning move. That is why many people are reluctant to implement risky strategies because of the potential to make a significant loss.
Therefore, traders will often focus their energies towards avoiding the loss altogether. This way, much focus is trained on the potential loss as opposed to the gains. A lot of people will ultimately opt for a smaller reward than risk the move in search of a more significant profit.
6. Bandwagon Effect
The Bandwagon effect points to human beings’ inclination to follow what other people are doing for various reasons, some of which are flimsy at best. This is evident in pop culture trends as everyone is out to ‘fit in’ with the crowd.
The bandwagon effect causes people to cede their way of thinking for the group mentality. From the onset, it has the potential to be disastrous especially when it comes to making financial decisions, e.g. during trading.
Trading information is spread across the internet. You might land on a forum that preaches the end of a bullish market run. Soon all the websites and news portals are abuzz with this prediction. However, you need first to conduct your analysis and confirm if it all holds water.
Failure to do so means you will be walking blindly into a trade. Since you didn’t conduct any analysis, you have no idea of the outcome, save for a couple of rave reviews on the net.
Trading is not a group effort. At the end of the day, if you made a loss, it will only hurt your account. Trading losses are never shared, and neither are the profits. Trading gurus whose advice you seek is probably unaware of the outcome of your trades and most likely do not care. Remember, only the wearer knows where the shoe pinches.
7. Recency Bias
Traders follow the prevailing market trend. The market behavior then informs a lot of trading decisions. However, trends reverse, and a lot of traders do get caught out because they had not anticipated this change.
The recency bias is seen where traders believe that the current situation will continue to hold out. This belief is drawn from how the market is behaving currently and in the recent past. So an uptrend that was prominent in the past two years will probably continue moving forward.
Recency bias is seen where traders only consider the short-term history of the market as an indication of the future. This bias is drawn from human’s propensity only to recall things that happened in the recent past.
When it comes to investing, recency bias can become your greatest undoing. The trading scene requires traders to consider a wealth of information. When the bias kicks in, you will only take into account far less data than needed.
When you choose inadequate information to inform your trading decision, you might as well trade with a blindfold because you lack the bigger picture.
Some traders who make long-term gains can, because of the recency bias, be inclined to quit because of a years’ worth of bad trades. On the other hand, others may be deceived by recent wins in the market without considering the losses that occurred at the start.
For any successful trading to take place, you need to do away with this bias. A long-term investment allows you to broaden your myopic view of the market. Think about your long-term goals as opposed to quick profits. Expand your perspective and get a proper understanding of your strengths and weaknesses.
Traders always have to keep a cool head. Do not be swayed by any significant but short-term profits as tend to obscure your initial goals. And finally, recency bias works with what you believe to be true. Set realistic expectations and work with what you can control.
8. Illusion of Control
This cognitive bias defines what a lot of traders struggle to accept. The market is an uncontrollable behemoth, and no matter all the stops you put along the way, lossmaking can occur.
Even in life, there are quite a few things which we have total control over, like the food we take or the clothes we wear. However, in a real-world setting, our power diminishes.
For traders looking to make a living, knowing what you can and cannot control is essential to your success. As an individual, there is a limited number of things you can control, so capitalize on these first before thinking about the broader pictures.
· Entry and exit into the market
Only enter a market you fully understand. Trading charts exist to help traders get a visual feel of the market at a time. It will be reckless to try and enter a market in which you have little knowledge. For starters, the lack of experience puts you at a disadvantage and you will only be putting your money up for grabs.
· Take profit
Setting reasonable profit targets after conducting a thorough analysis of the market situation. Now the fear of lossmaking compels traders to deviate from these targets and, in the end, make smaller returns.
· Stop loss
All traders need to be reasonable, more so when it comes to how their trading moves are running. The stop loss allows you to close the trade before additional losses pour in. Stop-loss orders are vital if you want to take out the pain of a failing trade. At the end of the day, it is way better to have your capital intact and live to trade another day.
· Mindset
Your trading psychology matters greatly when it comes to realizing success in this field. It is, without a doubt, harder to master cognitive biases. We then have to indulge in proper training and commitment. These go a long way in helping traders achieve the ultimate trading mindset.
Trading boils down to the analytics, and your emotions simply have no voice over your trading decisions. It is a well-known fact of how markets are often affected by major world events.
However, trading with scientific data on hand will give you a better view of the whole market over a more extended period, allowing for a better understanding. Take time to master your trading psych and learn to resist your emotions while trading.
9. Attribution Bias
The attribution bias points to how we tend to excuse our behavior or that which is exhibited by others without paying attention to reality. This bias is evident when we attempt to absolve ourselves from any wrongdoing to soothe our egos.
Typically, we often take credit for our successes and in case of a loss, it ever is our fault. When traders lose out on a trade, they blame just about everything else but themselves. However, your broker or even the president didn’t decide to enter or exit the market., that was squarely your move.
Confidence is a vital character to have and works wonders in just about all significant aspects of our lives from school to the workplace. So why does this crucial aspect of human nature spiral out of hand and cause us to deny any wrongdoing?
Regardless of the answer, traders need to take control of their actions and accept responsibility for any eventuality. So whether you make a profit or a loss, own it as you learn. After that, find out what went wrong and work towards improving your trading.
10. Hindsight Bias
Trading with hindsight knowledge can make you extremely rich. This is because you are probably aware of the outcome even before it happens. But every trader knows this to be an impossibility. No one actually knows what will happen in the future. All traders can do is analyze previous data to get a bearing of what the future holds.
Hindsight bias is the assumption that following an outcome, you hold the belief that you were aware of what would take place. Since you knew what was about to happen before it did, you then believe that you are capable of telling the future based on this off-chance.
Traders often attempt to enter or exit a trade at the perfect moment to capitalize on the value of an asset at the time. If you don’t time your move appropriately, then you will hold the thought that you saw the move, but you only were late to the party.
Such misguided beliefs take away the thought of an improper analysis, which could have brought about a failed trade. Your confidence in your supposed ‘ability to foretell the future’ grows and impacts your decision making process.
Investors ought to be keen on how they arrive at decisions. The future is uncharted territory, and relying on your gut feeling will only get you so far. Careful analysis, on the other hand, will help you overcome hindsight bias. Also, keep a record of your trading activities marking your wins versus the losses. This should tell you if you really saw it coming.
11. Neglect of Probability
Probability plays a massive role in global markets. Trading often takes place after one has evaluated all possible outcomes and settled on one with the highest likelihood of success. However, humans often tend to miscalculate when it comes to making decisions.
Neglect of probability is observable as traders violate decision making when they aren’t sure of how future events will pan out. Traders either have to compensate for the risk of a low-probability event or forego it altogether.
The outcome of any trade is not set in stone, and several results can be expected. Commonly, what a trader believes to be the best possible outcome is usually their best probability concerning the trade.
Other possible outcomes vary depending on the thought process used. Traders will ultimately have to take into account as many possible outcomes as possible to avoid being blindsided while entering the market.
Objectivity while trading is vital and can guarantee you immense success. However, as humans, we have to get past several cognitive biases to be able to trade objectively. It is quite easy to be overconfident, for example, and ignore warning signs. Ultimately, you will be trading at a loss. Therefore, traders need to understand their cognitive biases at work. This way, they can curtail it and work towards their intended goal.