Say what you may, read what you may, we are always biased — in political, personal and professional lives. Our choices favor one over the other without any rationale. But, these biased decisions tend to end up in our ‘regret-list’, more often than not. As a trader, you process numerous decisions in seconds — whether to go long, short or merely pass the trade. These trading decisions are susceptible to polarization as well, as the cognitive behavioral biases influence it.
You have a viewpoint to go short on a stock for the short-term, after thorough analysis, but a legendary investor, say Bill Miller, blurts on TV that he is long on the same stock for the long-term. The disclosure forces you to go back to the drawing board and reanalyze. Eventually, you set aside your analysis and either go long or dodge the trade altogether. The reason being, your cognitive biases haunt your mind and buzz your ears “the legend is always correct.” Ironically, both the analysis can be correct. The stock can be bearish in the near term and bullish for the long-term. However, you failed to capitalize on your thoroughly worked out analysis.
And there are many such types of cognitive biases that hinder your trading performance. Here’s a guide for you to help alleviate your trading woes.
Remember, although the investment community preaches rationality it benefits from the irrational decision of its peers.
#1 Confirmation Bias
As a human being, you like the friends who second your opinion, not the ones who doubt, question and tell the hard facts, face to face.
Likewise as a trader, after entering a trade, your eyes just focus on the candles (or bars) that validate your decision. And disregard the cues that contradict your view.
You enter a buy trade at a trendline. The market hovers around the trendline which you deem as support. After a while, a candlestick closes below the trendline. Ironically, you discredit it as a ‘bear trap’. It then rises to test the broken the trendline. Now, you cheer, feel vindicated, that the asset is rising. But, it doesn’t last long. It plummets leaving you stranded.
The market is like a perfect relationship. When you feel, you are reading your partner correctly; you are probably misreading.
It never is perfect with the market. So when you encounter one, always double-check.
Role play as your nemesis, be sarcastic, think of all the insane possibilities that can work together to take you down.
Because if your view was wrong, better be you the one that corrects it, than the market!
#2 Recency Bias
Your experiences define you. The most recent ones literally drive you.
The recent winners and losers always have a say in your next trade. Sometimes positively and the other times negatively.
On seeing a death cross that formed after a long uptrend, you enter a short trade. Contrary to your expectation, the market consolidates instead of correcting and then continues its upward journey.
The next time when you encounter a death cross or golden cross, you simply disregard it, failing to acknowledge a trend reversal. You leave out a chance to enter a ride at its kickoff point. You forget all the previous instances that helped you score. And you hold the one recent occasion close to your heart, in which it failed you. It is the recency behavioral bias.
Too much good is no good. It’s evil.
Reviewing your trades, learning from your experience is essential. But overdoing it by micro-analyzing is like a ticking time bomb. You don’t learn anything new; instead, you unlearn and overcomplicate things.
So, never make a trade decision at the backdrop of another. When you close out a position, winners as well as losers, draw out a cooling period. Define a time interval between one trade and another, as per your mode of trading- scalping, day or positional.
#3 Loss Aversion Bias
You prefer to avert a loss, at the extent of missing out a potential profit trade. It is the case of overdoing the ‘prudent’ part of investing. Although this behavioral bias does some good, it diverts you from your mission — profit making.
You are long. The market ticks up to your favor. Then it consolidates, in turn, oscillates a bit which sways your confidence as well. To cope up, you modify the stop loss level to your entry price. It seems a win-win situation for you. If it goes down, you are averting a loss. If it rises, you are to enjoy the profits.
Most often, a classical trader’s curse follows. The market just kisses your stop loss and skews north surpassing your target. Frustration. Wall pounding. Thud! Thud! Thud!
If the trader is a clock, profit and loss are the hands in it. It comes in pairs. The latter guides, helps and instills knowledge to the former. You can’t take one out of the equation and expect a valiant effort from the other.
Also, by any analysis, one can predict the destination of a rally but not its itinerary. So take out the break-even stops out of your system. Instead, use partial profit booking, when in doubt.
#4 Anchor bias
Like your first love, the information, interpretation or the analysis you make first influence you a great deal.
The subsequent information feels inferior and you assume the market will get around it.
You see a double top pattern after an uptrend in the chart. The pair moves a tad to your expectation.
To your awe, it surges upward to form a bullish flag pattern.
However, since you construed it as a double top pattern initially, you rejoice for forming a bearish trendline, failing to notice or shrugging off the flag pattern.
Dwelling in the past is always a curse, in life as well as trade.
Hold no sentiments to your analysis and interpretation but the money.
If you’re uncomfortable shifting your goal post (trade positions), better sit it out.
There is always another day, another trade, another setup.
#5 Self Serving Bias
This cognitive behavioral bias is the attitude of praising the self of success and cursing the external factors for failure.
If things pan out as per your plan, you attribute it to your prowess. When it doesn’t you find the market manipulative or yourself unlucky.
With the aid of a trendline, you take a long position and make profits, twice.
However, the next time when it braces the trendline, you enter a long trade only to see it break.
Unlucky! Isn’t it?
Attributing loss to luck, crying foul of manipulation — You are merely patronizing yourself. It isn’t going to help you in any way let alone harm you.
You are turning an opportunity to learn. Take the above analogy; for instance, you could have analyzed the cues that paved the trend reversal, before breaking the line. Instead, you passed on a chance to learn in the market.
Each time you lose, enter in your journal — what you deem the cause for the failure of your analysis. Make it a habit.
It is the real win-win situation for a trader. You either win money in a trade or learn something valuable from your loss.
#6 Herd mentality bias
Think of the times; you acted upon on sensational news, or on seeing sudden spike (or downpour) in charts without deliberation. This cognitive behavioral bias is the herd mentality bias.
An asset surges in the charts. Makes three back to back bullish candles. But you are utterly clueless about the market driver behind this move. On the contrary, you are confident that everyone is long on this trade.
Hence you hop into it, on the hope of making some quick cash, only to see it come down promptly.
Stick to your analysis and strategies. Don’t discard your plan as soon as a strong bullish or bearish candle pops out.
Also, news trading, expert opinions are not a technician’s piece of cake.
Remember, when you are clueless about the market movements, you are in hostile territory. You never can tell what follows next or what your stops for the trade. So stay away from the market. Simple!
#7 Status Quo Bias
This cognitive bias does not let you change your trading decisions in the middle of a trade, owing to discipline, confidence or laziness. You expect the status quo to be unchanged from your entry to exit. It is a hazardous behavioral bias since it doesn’t let you infuse flexibility into your system.
You go long on a stock with a long-term investment perspective.
You are decent gains after two years. But, the company’s numbers reflect a dismal performance subsequently.
Instead of deliberating the current fundamentals of the company, you hold on to the stock and your initial analysis, owing to discipline.
There are no stone wall carvings in the market. Both technical and fundamental analysis are prone and susceptible to changes.
You need to have flexibility in your system and constantly monitor and re-evaluate your trades, especially long-term trades.
Before entering a trade, define what it takes to change your forecast or prove you wrong.
#8 Neglecting Probability Bias
The quality of non-acknowledgment for the analysis to fail is the neglecting probability bias.
This cognitive bias poses a significant threat to a trader.
You see an asset at the bottom, at its support. You hear no negative views about it in the news.
Hence, you opt for a long trade without the stop loss, on the hope of the support to hold if at all a false break.
The result of the trade is irrespective since you have irrefutably succumbed to the bias here. Also, you have exposed yourself for an unlimited risk.
Record lows and highs break each day.
Every set up in the technical analysis have a stop loss which essentially means things can go wrong. So, acknowledge the probability of fallibility.
Adhere to risk management principles. Period!
#9 Impact Bias
The overthinking or over imagining of the impact of a particular outcome and the trading activity that ensues is the impact bias.
You are an intraday trader. You sense a long-term breakout in an asset and hence take an intraday position.
The breakout does happen. As a result, you expect the price to soar and close at the day high.
But the price action cools off and consolidates, and you miss the opportunity to close out at the highs.
The market has its routine. Sometimes it follows it; sometimes it doesn’t. The regular movements occur and recur in most cases, irrespective of the significance of an event.
So be pragmatic. And stick to the routine.
When you sense the happening of an out of the ordinary, then use partial profit booking strategy so that you can enjoy a piece of the pie before the market grabs it from you.
#10 The illusion of Control Bias
This cognitive behavioral bias lets you feel that you are in control of the market; in turn, you are in control of the outcome.
It is a common trading cognitive bias that ensues after a loss.
You have incurred back to back losses. You want to take it back from the market.
So you thoroughly analyze and come up with a so-called fool-proof setup, if at all such exist.
This cognitive bias does yield fruits, at times. However, other times it sends you spiraling down the path of hell.
It gives you a false sense of control and comfort in the market, which doesn’t last wrong.
And falling from high always takes a toll in a person’s confidence level and it takes time to restore.
So, embrace the uncertainty in the market. We are just reactors. We are to only react to the acts of the market!
#11 Backfire effect Bias
The cognitive bias which invigorates your conviction of a trade set up, owing to an outbreak of contradictory news or another formation is the
Backfire effect bias. You read it correctly!
You see the RSI indicator signal a bullish crossover in a currency pair and on further detailed analysis, you decide to go long.
Then, the GDP report of the country was released which was 100 basis points shy of the expectation.
Instead of going back to the board, you convince yourself that the ‘miss’ was already priced in. Also, you feel on seeing the data, most traders will be short and the market is going to ambush them. Apparently, it isn’t the case!
When you are at the halfway of your trading career, you experience this behavioral bias often.
The best way to overcome this trading bias is to approach the trade rationally like a chess player playing it on both sides.
Enact a roleplay, play the roles of bull and bear separately and list all the reasons for it to go up or down. Then, weigh the probabilities and make a rational choice.
Rationality always prevails in the market!
#12 Conservatism Bias
The tendency to cling onto the past analysis or traditional nature of the market, even if confronted with a new fact is the conservatism bias.
It is a common cognitive bias in investing and behavioral finance. Market evolves, yet traders are sulking in the past.
The market is in a long term consolidation and swaying within a specific range.
You identified the overbought and oversold zones of the sideways market with the Bollinger bands and made profits with it for a period.
The market breaks the range, one day. You are oblivious. Hence, you try the same tricks again and again, and it fails you. It takes time for you to acclimatize to the new patterns.
After all, you were a slow learner!
Hold no emotions. Hold no comfort zones.
The market evolves at its DNA level, like a tuatara. Hence, you have to be shrewd. Don’t resist the changes; instead, embrace it and use it to your advantage.
Note: Do not confuse the trend with the intrinsic nature of the market. The analogy used in the illustration is the case of trend change resulting in character change of the market. However, the inherent nature of the market can change without the trend reversal.
Take the recent case of the exodus of the safe-haven investors from gold to Bitcoin. Gold just lost its sheen as safe-haven (intrinsic nature) but did not render any structural change in price action. The traders who were quick to spot it made a chunk of profits with the Bitcoin.
#13 Blindspot Bias
The case of not able to identify one’s bias in decision making, albeit the knowledge of cognitive biases and its menace in trading is the Blind Spot Bias.
You see a friend who doesn’t take ownership of his trading failures.
You were able to identify the issue — self-serving bias and advise him.
But when it comes to you, you were unable to identify your problems- cognitive biases.
Humans are prone to bias. So, if you are finding yourself as ‘Mr.perfect’, then you are wrong.
To identify your problem, get help from someone else.
Or you can bookmark this page and read it often.
Once you get through the basics, trading becomes a psychological game. Hence you must evaluate your psychological decision making, just like your trades, as they are interdependent. So, try to pare down the effects of behavioral biases in trading and play to your strengths.