Biases are shortcuts that your brain takes to wiggle around complicated or tough decisions. They can have a huge impact on your day-to-day decisions. While this isn’t usually a huge problem, your biases may be holding you back from success in trading.
The human brain wants to conserve energy, and to do so; it will take shortcuts to avoid sensory overload. These shortcuts are often just fast mental decisions or shortcuts known as “heuristics”. The real problem with this is that we’re typically unaware that we have these biases. We must work hard and constantly challenge ourselves to counter the adverse effects that heuristic biases have on our trading and everything else.
While there are many forms of biases, let’s focus on two that have a disproportionate effect on your trading success. For these purposes, we must focus on cognitive and emotional biases. These biases are studied in the field of psychology. More recently, they’ve also been studied in economics and the new and valuable area of behavioural finance.
After seeing the effects of these biases on my trading and the trading of my colleagues, I noticed that seven key biases have a disproportionate influence on an individual’s trading. As you read on, try to ask yourself how these biases may have impacted your trading. Then, think about the ways you can prevent them from affecting your future trading.
1. Confirmation Bias
Confirmation bias causes us to seek out information that agrees with what we already believe and disregard information that suggests the opposite. Ask yourself, “How many times have I placed a trade then sat there and watched it go against me?” This happens occasionally, but when it does, where do you go to find information on why it happens? Are you seeking “expert” advice that tells you that you were always correct?
A colleague once told me; “many years ago, when I first started trading, I placed a large trade on oil. In hindsight, I didn’t know what I was doing, and the trade was too big for my account. I made a few mistakes as a beginner, including frantically typing “oil” into Google looking for any reason to support my original opinion that the price of oil would go up. Low and behold, there were investment banks providing information that agreed with my initial assessment. They talked about an undersupply in the market, explaining that oil was sure to go higher. It was 2 am at this point when I watched my whole account go into jeopardy. This valuable advice that I sought helped nurse me to sleep.”
Of course, none of this was beneficial. My colleague deviously chose not to click on any article that might tell them that they were wrong. They only sought out the information they wanted to hear or see.
2. The Endowment Effect / Sunk Cost Fallacy
The endowment effect is a psychological state that you enter once you own something for a long time. Effectively, this means we tend to value something more after we hold it for some time.
This “endowment effect” has been studied extensively. The studies and experiments concluded that we fear losing what we own so much that we place an abnormally high value on what we own.
Our loss aversion can have a significant impact on our trading success. For example, imagine placing a trade on EUR-USD, targeting a profit or loss of only 50 pips. Then, when the trade starts to go against us, what’s the first thing we often do? Move our stop loss further out because we “just know it’s going to turn around.” We tell ourselves stories like, “The Euro is cheap here; it’ll turn around.”
At this point, our commitment to this trade has caused us to allow it to become a sunk cost. We value it more because we own it and because we have already invested in it.
3. Recency Bias / Availability Heuristic
The “recency bias” or “recency effect” tells us that our recent experience can become the baseline for what will happen in the future. The human mind likes consistency and predictability, after all.
You can become a victim to this form of bias because of recent solid trade performance, such as a recent win or loss impacting you heavily. It can also come from a particular piece of news or information we recently heard, which then forms the basis for our decision making.
For example, imagine I gave you a list of items on a shopping list and then asked you to recall it. Chances are you would tend to only really remember the things at the end of the list. This form of bias can have dangerous consequences for us as traders. It undermines our ability to form an objective decision on a trade. This is because we tend to focus too much on our most recent trade or information we found as a barometer for how the next trade will go.
We also tend toward the fear of missing out (FOMO). With this new information, we feel we must put something into action!
So, how do you overcome this bias? As difficult as it may be, you must stop and count to three and ask yourself a few questions:
- “Why am I making this trade?”
- “Does it fit in with what I know?”
- “What am I missing here?”
- “Could there be a bias at play affecting my decision making?”
- “How can I look at this objectively rather than emotionally and not let my recent trades/ideas affect my judgment?”
4. The Gambler’s Fallacy
The gambler’s fallacy kicks in when we believe that previous events alter future probabilities. This effect is known as the “gambler’s fallacy” due to behaviour often observed in a casino. Imagine a roulette table; every time the game is played, the ball somehow lands on black repeatedly. Onlookers see this happen and think, “it couldn’t possibly land on black again”, and proceed to bet against it.
As traders and human beings, we tend to believe that if something happens multiple times, it couldn’t happen again. We thus ignore simple probability.
As an example, a bit closer to home, let’s say the S&P500 has rallied for five days in a row. So, we place a trade in believing that “it must be due for a correction” only to watch the index rally for the sixth day.
If you want to combat this bias, it’s essential to look at the original factors that got you interested in the trade.
5. The Bandwagon Effect
The “bandwagon effect” describes our inclination to do or believe things just because others do or think the same. Also known as “groupthink” or “herd behaviour”, it can lead to a severe trading hangover. During your trading hangover, you ask yourself questions like, “why on earth did I go long on the EUR-CHF last night?”
A recent example of this effect was the Federal Reserve’s first-rate increase since 2008 by December of 2015. Following the event, commentators and fund managers surveyed by Bank of America-Merrill Lynch said, “buying US Dollars was the biggest one-way trade of 2016”. Most respondents believed the general market consensus that because the Federal Reserve said they expected four rate rises in 2016, the USD would surely rally.
Following that long USD trade would have led to disaster. In fact, the USD-JPY fell from as high as 121 to 101, an impressive 2000 pip fall from December! Be careful of those bandwagons!
6. Hindsight Bias
Everything is more apparent in hindsight. You could also call this bias the “I knew it all along” effect. How many times have you heard someone say those words in life, let alone in trading? We tend to believe that the onset of a past event was entirely predictable and obvious, even though we couldn’t predict it during the event.
Due to another bias called “narrative bias,” we tend to assign a narrative or a “story” to an event that allows us to believe that events are predictable. We like to think that we can somehow predict or control the future. It allows us to make sense of the world around us. It is now common to find stories of those who predicted the great recession and the US housing bubble in hindsight. They become legends or “oracles” that people look to in the future for advice, believing they will again be able to foresee any future turmoil.
It is essential to watch out for this bias. The hindsight bias leads us into perhaps one of the most dangerous mindsets: overconfidence.
7. The Overconfidence Bias
The overconfidence bias is our final bias and one that is typically less hidden than the others. Overconfidence as a trader allows us to believe that we are superior in our trading. This ultimately leads to hubris and poor decision making. It doesn’t matter whether it’s overconfidence on when to trade, what to trade, or how to trade a particular product.
This can all lead us to trade larger than we should, hold losers for longer than we should, or relax our risk management policy. Of course, this all leads to capital losses.
What’s Next?
OK, so I might have scared you. You may be jumping at shadows and questioning your own trading decisions, believing you have all these secret, hidden disadvantages that you didn’t have until 10 minutes ago, but don’t worry. Biases can not be completely avoided, but we can work hard on challenging our opinions to make us more successful. Sometimes all it takes is just a moment to stop and think.
To help you along the way, we’ve created a possible checklist for making better decisions in your trading.
So, stop, take a breath and ask yourself these seven questions before you place your next trade.
1. Why am I taking this trade?
2. How strong is the evidence behind my decision to trade?
3. Could I be missing something?
4. Is there evidence to consider the opposite side?
5. Has the recency of information I’ve learned influenced my decision? If so, how much?
6. Is this trade following the consensus of the crowd? If so, is that a good thing?
7. If none of the above questions applies, could any of the other biases above be at work?
