The biggest cognitive biases for traders and why we think they matter

The biggest cognitive biases for traders and why we think they matter

Not all your thoughts are facts. To become a better trader, actively challenge your thought patterns and cognitive biases.

All humans have cognitive biases that affect the way they judge situations and react to them. Traders are no exception. Traders are often nudged by instincts and impulses which interfere with their ability to make rational financial decisions. As a result, it may lead them to make mistakes, lose money or never reach their full potential. These thought patterns are like shortcuts that the brain uses to process data and information automatically. They are commonly known as biases or heuristics.

Learning how to identify cognitive biases can help traders gain insight into their own behaviour and train themselves to make better and more balanced decisions. Let’s have a look at the most common biases that affect investors and their judgement and at how you can train yourself to overcome them should you wish to. These include eight major biases: anchoring, loss aversion, recency, confirmation, bandwagon, self-serving, hindsight and hot hand fallacy.

Anchoring bias

When we are asked to make a decision we sometimes tend to anchor on the first piece of information that we are offered. In trading, this could be the first trading session sentiment. If the day starts off looking bullish, for example, we might tend to believe this will be a positive day, even if later there are clear signs of exhaustion. The same holds true if the day starts off looking bearish. In that case we might feel reluctant to take risks, even if there is a clear upturn later during the trading day.

Why is anchoring bias common? As humans we subconsciously need a point of reference to help us make a decision and we usually overemphasize first impressions.

To overcome anchoring bias traders can use tools such as deductive reasoning skills and checklists or assessments. Another way would be to delay taking action as much as possible and seek additional information until a satisfactory decision is reached.

Loss aversion bias

No one likes the feeling of losing, but when the fear of the risks occurring interferes with the chance of winning, traders could be affected by loss aversion bias. Loss aversion is the human tendency to prefer avoiding losses to acquiring equivalent gains. Loss aversion examples in trading include investing only in safe products, selling a stock just because the price is higher than the price you paid just to lock profits, refusing to sell a stock below the price you paid for it because you don’t want to take a loss as well as focusing all your energy on one investment that has lost money instead of other investments that are winning.

Why does it happen often? Loss aversion is an emotional or psychological reaction when the pain of losing is twice as powerful as the pleasure of gaining. It’s fear getting the best of you. Its deeper causes can be traced in our neurological makeup, socioeconomic factors but also our cultural backgrounds.

To avoid loss aversion, it’s important to understand that a good trader understands the need for volatility and risk. Building discipline, patience and allowing the price to hit a stop level of target could help traders control their emotions and use rationality and logic instead of impulse.

Recency bias

Similar to anchoring bias, recency is a memory bias that happens when we overvalue the most recent information that is available to us. It’s the inability to see the whole picture. In trading, examples of recency bias could be relying on the most recent news or information about stock performance rather than taking into account long-term volatility. As a result, traders could believe that a recent market rally or downturn could extend into the future.

Recency bias is a very common psychological human reaction that affects almost every aspect of our lives, not just trading. To keep it in check it helps to consciously focus on the larger macroeconomic background and look at the bigger picture. Keeping a trading journal, determining a trading strategy and trying to stick to it, as well as actively monitoring one’s emotions are some things that assist in managing recency bias.

Confirmation bias

It’s very likely that you have heard confirmation bias before. It is a very common psychological tendency where we favor information that confirms our existing beliefs and hypotheses. We subconsciously look for information that supports our preconceptions, while we ignore or filter out information that is conflicting. For example, investors could rely on selective news or information to decide if they want to buy certain stocks, thinking that they make a rational decision. Confirmation bias can lead to overconfidence, but it can also lead to a pessimistic “bearish” view of the market that doesn’t reflect reality.

A way to overcome confirmation bias, is by traders actively stepping out of their comfort zones, formulating multiple hypotheses (ideally identifying three potential causes) and proactively trying to challenge the initial assumptions. When dealing with confirmation bias onecan practice the following:

  • Develop an alternative investment plan

You might already have an investment thesis, but is this the one that serves you best? To try the hypothesis, think about possible issues with the existing plan and be more willing to internalise the information that contradicts it. Building an alternative investment case could allow you to interpret data in a less biased way. This trick also helps train your mind not to reject contradictory information in the future without careful consideration.

  • Actively seek out alternative opinions

You might also adopt a contrary viewpoint to your own and argue the opposite side for the sake of argument. This may help you detach yourself from the initial assumption.

  • Be accountable

People are more likely to try to think critically when they are accountable to others and they have to justify their decisions and actions. Involving others in your decision making may help you achieve that.

Bandwagon bias

As humans, we have a tendency to belong, conform, and do things just because other people are doing them or believe them. Bandwagon is a very powerful human bias that prevents us from thinking for ourselves and making the best decisions based on the information that is available to us. The bandwagon effect is fairly common and it is also known as “herd mentality”. The need to herd is innate and it is prevalent in many animals but also in humans.

In trading, bandwagon bias is very common, so common in fact that there are trading apps whose main purpose is to copy other people’s strategies. But is this a sound trading strategy?.

Investors feel more reassured when they know that they are making the same trading decisions as other people. While this can lead to a trading frenzy that could drive prices, (a good example for this is Reddit-backed meme stocks), buying “hot stocks” doesn’t always deliver the results we hoped for but can result in the opposite: selling en masse.

The bandwagon effect can spread like a wildfire so it’s important to use the appropriate techniques to overcome it. These might include:

  • Distance yourself from the bandwagon cues

Take a step back from social networks where you detect peer pressure to invest in certain stocks and re-assess your situation.

  • Slow down your reasoning process

The bandwagon effect can be very fast-moving. Slowing down your reasoning can help you distance yourself and think through the situation in a slow and analytical manner.

  • Create optimal conditions for decision making

Take time and find the space to properly concentrate, this helps to resist the impulse to buy or sell in the heat of the moment.

  • Examine the bandwagon.

Who is promoting the bandwagon and who will benefit more? Addressing these questions will help you understand if this is indeed a real opportunity or not

Self-serving bias

Self serving bias is also known as self attribution bias and it takes place when investors attribute good outcomes to skill and bad outcomes to luck. Self-serving bias is harmful and insidious because it limits your ability to learn and develop your skills. As the saying by Mark Cuban goes “Everybody is a genius in a bull market”.

For example, you might buy 20 shares of stock A. If stock A goes up and reaches 100% profit, you feel like you are infallible. If on the other hand stock A plummets, you put it down to bad luck and because the market threw you a bad hand. Letting ego and overconfidence get in the way of your personal development as an investor is not a great approach.

To overcome self serving bias you could keep an investment or trading journal where you record your strengths and weaknesses. This will also help you identify the most common mistakes that you make.

Hindsight bias

Hindsight bias is a rather dangerous psychological phenomenon when someone becomes convinced that they accurately predicted an event before it happened. This can lead people to believe the illusion that they can accurately predict events and they “always knew” deep inside that they were right. If they had this special insight or talent, however, why did they make a mistake?

An example in the financial world can be, for example, claiming to be able to predict that the market would crash. Many people can convince themselves that they had this knowledge, but if you examine history it is easy to see that if they actually did, they would have taken action in time. Hindsight bias is dangerous because it prevents traders from learning from both their mistakes and their wins. It causes overconfidence, prevents you from taking responsibility, therefore blaming others, and giving simplistic explanations to complex events.

Keeping an investment diary helps investors record and map the outcomes of their decisions, as well as the thought patterns that led them to those decisions. Be aware and record your thought process before making a big investment decision and justify your choice rationally. You can include your suspicions, hunches and feelings to this as well as any proof.

Also, know that there is no crystal ball that can predict the future and that you should consider the objective data. In the diary you should also include alternative outcomes that could occur because of miscalculations. Trust the process, not the outcome.

When you do have an outcome, you will be then able to analyze it and address the following questions:

  • How correct were you?
  • How was the outcome compared to your predictions?
  • Which factors made a difference and which factors didn’t?

Hot hand fallacy or extrapolation bias

You might be able to guess what hot hand fallacy is. Some traders believe that their ‘hot hand’ is on a winning streak, and that they therefore can’t lose. Economists refer to it also as extrapolation bias.

The hot hand fallacy is a way to misinterpret randomness and make incorrect conclusions, just like when you toss a coin in the air. Hot hand can extend to the mindset people use to choose fund managers: If the fund managers have a successful background, investors expect them to continue the high performance track record. It can moreover be linked to recency, confirmation and hindsight bias, as well as overconfidence, to name a few.

To avoid this very common trading bias it is important to understand that no matter how many successful trades you’ve made in a row, there is no such thing as a “hot hand”.

Conclusion

Becoming a successful long-term investor is not likely to happen overnight. It is a gradual process of self-exploration and self development where you will learn many things not only about trading, but also about yourself. We consider overcoming cognitive biases an important aspect of this journey. Some online brokers actively try to engage traders in this process and teach them how to identify, observe and overcome their biases through trading education and psychology guides that include in-depth analysis.

The article contains market commentary information, it should not be regarded as investment research or investment advice. Past performance is not a reliable indicator for the future.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 76.25% of retail investor accounts lose money when trading CFD

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