Over the next two episodes, we are going to introduce you to the seven common cognitive biases that impact our decisions as traders.
By building awareness of these common biases, you will be in a better position to identify them in real-time so that you can reframe your mindset right there and then in order to make better trading decisions going forward!
When money is on the line and time is limited, human decision making can be flawed and trading is one of those fields where irrational behavior patterns can be quite common.
So being aware of these cognitive biases can provide a trader with some advantages - namely - it helps you better manage these in your own trading, but also, they can help you understand some of the reasoning behind the moves in the market that may seem irrational!
Let’s quickly take a moment to look at some of the reasons why cognitive biases can be bad news for traders:
Effects of Cognitive Biases
- Missing out on valid setups because of preconceived notions of price
- Cutting winners too early and holding on to losers
- Deviating from your trading plan
- Building a reliance on crowd-driven information & opinions
- Handcuffing trades and getting whipsawed
Now that you are more familiar with some of the effects of feeding into these cognitive biases, today, we'll focus on four of the seven.
#1. Confirmation Bias
- This occurs when you seek out information that confirms your preexisting beliefs.
- The majority of traders have been guilty of this!
- Said differently, the confirmation bias means we ignore inconvenient information.
- We tend to place a lot more weight on the information that confirms our ideas and trades and filter out the information that does not agree with it.
- Let’s say for example that you are in a losing trade and then you find information online, maybe it’s news or a trader you respect that supports your trade idea.
- Because this information supports your bias, you may end up holding on to the trade despite what the market is telling you!
# 2 Loss Aversion Bias - Nobody likes to lose, it’s simply human nature, in fact, most people would rather not lose than win!
- At its heart, this cognitive bias does not accept that trading losses are part of daily business operations.
- This type of cognitive bias is rooted in your top values being security and safety and that taking a loss in the markets affects your safety.
- This basically means that you will not act because you are fearful of losing money- you will hesitate to take trades.
- You have to pay to play; the money in your trading account should not be money you need to survive; have to find a balance between not being in gambler mentality and not to be averse to losses.
- There is a big opportunity cost to this; if you are not taking a trade when your edge is present you may be missing out on potential profits.
- Related back to trading, let’s say you get into a short position and the market dumps lower and you quickly move your stop to break-even - you might subconsciously be handcuffing the trade in order to take the risk of a loss off of the table.
#3 Recency Bias - Refers to illogical ways of putting more importance to recent events compared to historical ones - our brains tend to put more weight on recent experience.
- If an outcome has recently happened this way, you're going to then think that it will continue to happen that way.
- Just because it happened recently, does not dictate that future outcome
- We are more affected by losing trades, so we avoid trades that remind us of the recent losses.
- Using a trading-related example, let’s say that you’ve taken a handful of pullback trades in a healthy trend and were stopped out on all of them; you might pass on the next valid setup because you have concluded that trading pullbacks is a losing strategy, so you might try a new strategy instead thus giving up your valuable edge
- Abandoning logic and your trading plan because of emotions.
#4 Sunk Cost Fallacy (aka Post-Purchase Rationalization)- After buying something we tend to rationalize and prove that our purchase was right
- Sunk cost is not a good perspective to be making decisions from!
- For traders, the most common purchase is getting into a trade
- Let’s say you waited patiently for a setup to form and you took the trade, but as soon as you get filled and it starts going against you - sunk cost fallacy starts to creep in.
- You spent a considerable amount of time waiting patiently for the setup to form, disqualifying lower quality trades in the process, so you refuse to accept that THIS one trade might be a loser - after all - you did your due diligence, however, despite warning signs that the trade might not work out, you rationalize that it is a good position and give up your chance to scratch for a small win/loser.
Some Things We Discuss in Today's Show:
- The advantages of understanding and identifying cognitive biases 02:06
- The negative effects of cognitive biases on traders 03:46
- Breaking down the confirmation bias and how traders ignore "inconvenient" information 09:04
- The loss aversion bias and why most people would rather not lose than win 16:50
- Why the recency bias can have you skipping out on your best trading setups 26:56
- The sunk cost fallacy and rationalizing your trades based on time and capital already invested 34:50
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