In today's episode, we continue our discussion on the common cognitive biases that traders deal with and we close out this series with some actionable steps that you can take to overcome these biases in your own trading!
Last week we introduced why cognitive biases can be a bad thing for traders and also identified four of seven common cognitive biases that we deal with as traders.
If you haven't had a chance to listen to part one of this series, we suggest you listen to that episode in full in order to get up to speed for today's discussion!
As a quick refresher, last week we introduced the following cognitive biases:
#1. Confirmation Bias
- This occurs when you seek out information that confirms your preexisting beliefs.
#2. Loss Aversion Bias - This means that you will not act because you are fearful of losing money - you will hesitate to take trades.
#3. Recency Bias - This occurs when you put more importance on recent events compared to historical ones - our brains tend to put more weight on recent experiences.
#4. Sunk Cost Fallacy - After buying or investing time into something (planning and executing a trade), we tend to rationalize and prove that our purchase was right due to the time and capital already invested.
This week we close out this list with the final three common cognitive biases we face as traders:
#5 Overconfidence (Hot Hand) Bias
- Based on the irrational view that consecutive winning streak will continue because of the previous streak of winners.
- If you start winning trades consistently, you can succumb to overconfidence by starting to take trades that are not part of your high-quality setups.
- OR you may think that you have a hot hand and that your next trade will be a winner, so you scale up the position size.
- Generally, previous successful outcomes do not influence longer-term performance because each moment in the market is unique.
- The issue with overconfidence is that you might start taking shortcuts and relying on instinct for your trading decisions.
- Falling victim to the overconfidence bias can have you giving back a majority if not, all of the gains from the hot streak
#6. Gambler’s Fallacy- One of the most common human biases and is the opposite of the recency bias
- It occurs when you start to believe that because a certain result happened more frequently in the past, there is a higher probability of a different outcome in the future.
- Think about roulette for a second - the ball may land on black several times consecutively - the gambler fallacy is based on a premise that the roulette ball must land on red very soon, however, a roulette table has no memory and a spin of the ball has no connection with previous spins of the wheel.
- Over a large enough sample of trials, a red or black number will be evenly split, but they are randomly distributed in smaller individual samples.
- Similar to trading, just because you lost the last 5 trades does not mean that the 6th trade “has to go your way” and will be a winner.
- There is still a statistical likelihood that’s the same across all those outcomes - this is why the martingale method is so dangerous!
- The fallacy is when you start to believe that the probability of one happening over the other has increased based on the previous streak!
- This tendency arises out of an ingrained human desire for nature to be constantly balanced or averaged.
#7. Anchoring Bias- The idea that we use pre-existing information as a reference point for subsequent data.
- This cognitive bias refers to giving too much weight to the “anchor” when we make our decisions - the anchor in this case being the first piece of information offered.
- An example would be something like being the first to name a price during negotiations as this will set the tone for the rest of the negotiation.
- In the context of trading, we often anchor on our support and resistance levels or entry levels.
- When we anchor to these levels, we often anchor to what they should be doing (based on pre-existing info) rather than focusing on the factors that we see - factors that could push price through our levels.
- This could be holding on to a bias based on the information you initially received “ ie. If the market opened the session on a strong sell-off, you might convince yourself that the session would be a bearish trending day".
- If the market fails to follow through on the sell momentum and reverses higher, you may be stuck looking for short positions despite the fact that the market is clearly showing you something different.
- As the market offers new information in the form of price action -we must analyze it- however, some traders remain anchored by the original information received.
- You are effectively ignoring the new data because you are anchored to the information that was originally provided on the open.
Being aware that these biases exist is an important first step, however, they are so deeply ingrained in our psychology that knowing about them is not enough to manage them!
That being said, there are definitely some actionable steps you can take in order to improve the quality of your decision-making.
How exactly can you accomplish this?
Plan your trades and trade your plan - you should not have to be making split-second decisions under the gun when you are trading.
Have a good trading journal with a large data set to quantify your edge is another way to mitigate the chances of emotional decision making while trading.
Actively monitor yourself for these cognitive biases in real-time- now that you are aware of them you can implement a check-up on yourself to ensure you are clear-minded and objective.
Talk aloud to yourself in real-time and analyze how you are feeling!
Reduce your active stimuli - commit to trading the market during predetermined times! The more you sit in front of your screens, the more stimulus your brain receives, and the more likely you are to have an emotional response!
Some Things We Discuss in Today's Show:
- How the overconfidence bias can lead to emotional trading 06:15
- The gambler's fallacy and why it doesn't have to be different this time 12:30
- Why anchoring bias can put (and keep) you on the wrong side of the market 23:49
- Why volatility can have you anchored to certain expectations 27:30
- Most people fail their plans before their plans fail them 37:20
- Keeping a trading journal to track how well you execute your plan 41:40
- Using mental checks to actively monitor for cognitive biases 44:50
- Reducing your active stimuli to prevent boredom trades 52:00
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