5 Cognitive Biases That Neglect Your Trading Performance (and the solutions)
Introduction
The market is a picture painted by human behavior and emotions.
A trader must first understand how his brain works to find out ways of working with his emotions and especially, overcome his cognitive bias.
In this article, we will discuss the most common cognitive biases that a trader has to go through and their solutions.
#1 Anchoring Bias
The common human tendency to rely too heavily on the first piece of information offered - the "anchor" - when making decisions.
A good example of this in the trading world:
A trader reads news events that are bearish for Euro.
Later, he makes his analysis of EurUsd and realizes his strategy tells him to go long.
In this scenario, the trader would most likely avoid opening a buy position on EurUsd or even try to find reasons to sell the pair based on the first piece of information he read.
Consequently, he ends up not following his strategy because of the bigger weight he puts on the first information he acknowledges - the bearish new event.
While if he would've made his analysis first and only then, looked at the trading calendar, he would've entered long on EurUsd.
How can we get over the anchoring bias?
Be aware of this phenomenon the moment it takes place. Once we are aware, we can put the same weight on both events: the one we acknowledged in first and in second. From there, it's easier to make a rational decision based on the information we have.
A solid entry process coupled with known stop loss and a well-defined exit plan. If the trader has a well-defined strategy to enter the market; places his stop loss as he enters without moving it later; and has a structured exit plan that leaves no doubts when closing a trade, this trader is armed with the necessary preparation and system to not let his emotions take the best out of his trading. He knows his strategy well enough to not let being influenced with extra information.
#2 Loss Aversion Bias
The people's tendency to prefer avoiding loss to acquiring equivalent gains.
Due to this, traders tend to hold on to losses because they don't want to experience the pain that comes with realizing a loss. This gives them the hope that the trade will turn profitable ending up taking no action - cutting losses small.
Example: If a trader made $500 on a trade and is currently losing $100 on another, the loss of $100 will overpower the joy of making $500, and so he might end up holding the losing trade in the hope for it to turn profitable just to avoid the grief that comes along after booking a losing trade.
Another example, this time outside of the markets is in marketing campaigns such as free trial periods. As the buyer incorporates that specific service or product into their lives for free, they are more likely to purchase it when the free trial ends, as they want to avoid the loss they will feel once they give up the product.
How can we get over the loss aversion bias?
Having a good risk management model in place. When the trader is disciplined and experienced enough to know that one loss is not the ruin of his account, he avoids being influenced by his emotions to make decisions. The trader observes his emotions & decides whether they serve him well or not, putting a hand on his behavior.
Detach from the outcome of one trade. Trying to control things you are not able to cause anxiety and frustration. When you recognize that you don't need to control more than yourself to profit in the markets, you'll no longer judge your trading depending on the result. This releases a great amount of unnecessary anxiety.
Look at the bigger picture. Look to your trading journal and put that loss in perspective. How does it affect your overall performance and results? When together with your last trades, you gonna have a more reliable perspective of the impact that loss causes on your account. This allows you to control your emotions better and make smarter conclusions.
#3 Hindsight Bias
The inclination to see a past event as having been predictable, despite there having been little to no basis for predicting it.
For example, when you are backtesting a specific price pattern, it seems to work perfectly. However, when the same pattern occurs in real-time, you might have difficulties identifying it and trading it.
This happens because when you're backtesting, you're testing events that already happened so you already know the outcome. This highly affects your judgment of what you're testing.
Another example, this time a real-life one, is when you overcome a difficult challenge or situation. When you look back, it might seem that you struggled more than necessary. Now that you overcame the challenge, everything seems easier. The confidence you gained from overcoming that situation blurs your judgement of it.
How can we get over the hindsight bias?
The hindsight bias affects our judgment in 2 main tasks:
When backtesting & studying winning setups;
When reviewing our wins and losses of the trading journal.
The solution:
Study your winning and losing setups in 2 steps:
At the moment of the entry (remove price after entry point).
After the trade is closed.
For backtesting: Save two different screenshots and go over them frequently.
Without the "after" part, you can make a non-biased decision as if it was real-time. This way you'll develop your pattern recognition skills.
For win/loss analysis: Take a screenshot at the moment you enter the trade and another when you close it.
This way, you'll pay closer attention to what happened before you entered the trade and what made you enter, making a fair judgment on what you can improve.
#4 Confirmation Bias
Seeking out information that supports an initial thesis while disregarding all else.
It creates a kind of a filter in the mind of the person which keeps ignoring the information that goes against his/her belief.
Example: If a trader has entered long on EurUsd, he will be more prone to search for reasons that support his trading idea rather than not.
This happens very often when a trader marries a trading idea. He searches for information on the chart that supports his trading idea. In doing this, he analyzes the pair to confirm his emotions rather than his strategy. This leads him to disrespect his strategy and disregard all the counter-information to his idea.
Our perception can be our best friend or our worst enemy.
This happens all the time in our daily lives. It's part of our human nature. When we hold a belief, we perceive all the outer information as supporters of that belief. If the information contradicts our beliefs, we can get angry and make up a way to dismiss that information. Our brain sees it as useless and doesn't memorize it. This is the way our perceptions affect our behavior.
How can we get over the confirmation bias?
How can we not marry trading ideas?
To arrive at a solution, we first need to understand WHY traders tend to marry trading ideas.
So here is a case study:
There was an experiment where professional horserace handicappers (people who bet on horseracing) were asked to estimate the likelihood of certain outcomes of horseraces before they had placed any bet. Then, they had to actually make a bet on some races. After they had placed their bets, they were asked again how certain they were about the outcome of the race.
The findings were very obvious; after they had placed their bet, the professionals were much more certain and convinced that their decision was the right one, even though nothing had changed.
What happened that made the professionals take a much stronger opinion after putting down the money?
The psychological phenomenon at work is called “cognitive dissonance”. As humans, we like harmony and order in our lives; if something is not going according to plan, we fix it and find solutions to bring everything back into a state of order. Cognitive dissonance is “the unpleasant emotion that results from believing two contradictory things at the same time.”
The horse bettors bet their money on a certain outcome and in order for them to achieve a state of harmony, their minds made them believe that their decision was the right one. It creates a lot of stress if they would have started doubting their decisions and we usually do everything to avoid doubts and stress.
In trading, it works exactly the same. We buy a certain instrument because we believe that price will go up. But, if prices start falling and our position moves against us, we look for information that confirms our initial idea. We try to create a state of harmony and congruency by creating a strong sense of certainty.
The more price goes against us, the more certainty we need to avoid cognitive dissonance, which then creates the effect of “being married to a trade”; we can’t cut our loss because it would confirm that we were wrong.
So what really creates this bias is the attachment to certainty. In trading, we know that we need to embrace uncertainty to profit. However this totally goes against our nature, that's why it is so difficult to be ok with uncertain outcomes.
How can we embrace the uncertainty of the market?
Having a well-defined trade management plan;
Thinking in terms of profitable and non-profitable instead of right and wrong;
Thinking probabilistically - risk management;
Developing good trading habits.
So it's worthless to have experience in trading if you are executing the wrong behavior.
Only when you feed the good habits, is that you can overcome this strong bias!
#5 Bandwagon effect
The human tendency to want to conform, be part of the crowd; do things because others are doing.
Example: A trader goes long on EurUsd, not because of his strategy, but because two of his friends do that.
He ends up disrespecting his strategy to satisfy this bias & follow the herd.
How can we overcome this bias?
Never listen to market commentaries and news when you trade. Use them only the preparation and research time.
Build a strategy you trust and that is personal to you;
Trade what you prepared for. All extra information will interfere with your decision-making by putting emotions in the game. Don't let yourself be affected by last-minute information or other traders' opinions.
Develop self-confidence and critical thinking!
Our society taught us to go with the herd and not question "the rules". This atrophies our critical thinking muscles that are not used.
If you "get out of the box" and develop your own identity by questioning the world around you, you'll understand there are many beliefs you own because they were imposed on you; you didn't really thought about them nor chose to own them.
Spent time thinking about them now: make questions to yourself; develop your own thinking and most important: develop the self-confidence to act according to what you think is right!
The long-term view is key in trading. Don't let yourself be affected by short-term events that seem to give you short term gratification.
Conclusion
The skills required to profit in the markets go against our human nature.
When you become aware of the brain programs that neglect your trading, you can make fair judgments about your emotions and put a hand on your decisions.
Are you making a decision based on your emotions? Or based on your rational brain?
Is these question that you need to ask yourself every time you're trading. The answer is within you.
I hope you can now identify better what's causing you to struggle with your trading.
Have a great trading week :)
See you next time.
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