Having biases is a pretty normal occurrence in trading since it mostly involves having an inclination for potential market behavior based on data.
However, some cognitive biases can turn out to impair decision-making, as these tend to cloud our ability to read the markets objectively and make good trading decisions.
Among the more common biases include:
- Recency bias: Placing too much importance on the latest events and failing to see the bigger picture
- Confirmation bias: Paying more attention only to data that supports our existing view
- Herding bias: Tendency to follow the majority and fear of straying from the crowd
- Attribution bias: Taking ownership of strengths but blaming external factors for losses
In his book “Thinking Fast and Slow“, author Daniel Kahneman lists a bunch of other cognitive biases that typically impact human behavior. Here are some that might also be applicable to trading:
1. Loss Aversion
Ever caught yourself hesitating or backing out of what could’ve been a good trade just because you’re down in the dumps during a drawdown?
As its name suggests, loss aversion kicks in when an individual prefers to avoid losses over acquiring potential gains due to the risks involved.
While there is some element of damage control and self-preservation involved, it also helps to remember that in trading you gotta risk it to get the biscuit!
For a trader seeing back-to-back losses, losing $100 could feel more painful than gaining $100 feels rewarding, which can skew decision-making towards overly cautious behavior.
2. Hindsight Bias
Kahneman illustrates hindsight bias being in play when people believe they would have predicted an outcome… after the event has already occurred. In short, this happens when somebody goes “I KNEW IT!”
This kind of bias can distort learning from past experiences because it creates an illusion of predictability, leading to a overconfidence in one’s “foresight” instead of pinpointing lessons learned or what could’ve been improved in analysis.
3. Anchoring Bias
This one is somewhat related to recency and confirmation bias in which individuals rely too heavily on a piece of information, this time being the first encountered (a.k.a. the anchor), when making decisions.
For instance, seeing a $1,000 price tag on a sneaker could lead to an inflated view of its value, thinking that a 20% discount on the offer is a good bargain.
In trading, anchoring bias can occur when “leaked” information comes out and influences expectations for a particular event, even prompting some to ignore more pertinent data points released afterwards.
4. Availability heuristic
This pertains to people’s assessment of the likelihood of events based on how easily examples come to mind, similar to how anecdotal evidence can support or negate beliefs more strongly than conducting actual research.
In turn, this could lead to overestimating the frequency of drastic events (ex: plane crash, shark attacks) even though they occur less commonly than other risks (ex: road accidents) that are less sensationalized or memorable.
In trading, availability heuristic comes in play when investors react to recent news events or market trends that are vivid or dramatic (ex: market crash, major earnings misses), potentially leading to impulsive behavior or disregard for proper risk management.
Staying aware of these cognitive biases can help you take a step back from making less-informed trading actions based on distorted views. Recognizing that a bias may be in play can enhance your objectivity in making more rational decisions.