Finding a profitable strategy in the complex world of trading is half the battle. The other half is often within ourselves. Our minds, with inherent biases and cognitive errors, can sabotage our trading as well as slowly erode potential profits. Confirmation bias to loss aversion, these subliminal traps lead to costly mistakes that will often ruin even the best laid of plans.
Trading biases are as important to any trader as wishing to be successful. Cognitive errors not only influence individual decision-making but also deform our perception of behavior by market. This article will go through the most prevalent trading biases, their effect on our trading decision, and some practical strategies in how to reduce their influence.
By identifying and getting over these biases, traders can optimize processes to make decisions, limit emotional interference, and gain more profits. Let’s go through the most common trading biases and how you can counter them.
What Are Trading Biases? Trading Bias Definition
Trading biases are cognitive errors or behavioral mistakes that result in limiting clear and rational thinking. They are systematic rather than sporadic, meaning they occur regularly. When trading falls prey to biases, sound judgments become overtaken by emotions and may result in irrational choices.
Morgan Housel, one of the most famous financial writers, succinctly wrote: “Investing is not the study of finance but the study of how people behave with money.” It would become indispensable to know your trading biases in order to understand your limits as well as to make important improvements in your strategies.
Common Trading Biases
1. Optimism and Pessimism Bias
This bias manifests itself as an inability to think long term. When on a winning streak, traders are likely to be overoptimistic, which leads them to increase positions violently. After losses, one is likely to fall prey to pessimism, thus reducing his positions or even completely quitting trading. Such an emotional rollercoaster can seriously hamper trading performance.
2. Anchoring Bias
Anchoring is that act of concentrating on a particular price, most often a previously traded price, and using that in decision-making in the present times. Take this example: A stock traded at $100 once. The buyer waits for it to come down to that again before buying the stock, although the stock is upwards moving. Such concentration turns out as forgoing an opportunity because the market does not work according to our mental anchoring.
- Loss Aversion
The largest of biases that traders have would be loss aversion. Losses are felt much more profoundly than gains that are equivalent in value. Hence, the loss for instance of $10,000 is felt more than the earnings for instance of $10,000. That can lead to a reluctance to make trades or to hold onto losing positions too long in hopes of recouping losses.
4. Confirmation Bias
The traders tend to look at information that confirms their beliefs but ignore something that goes against it-a typical confirmation bias. For instance, if you believe a particular stock is going to rise, you ignore all bad news or data that appears. That may create an unbalanced perspective and poor decision-making.
5. Fear of Missing Out (FOMO)
FOMO represents the bandwagon effect in traders being forced to join the crowd into which others have entered usually because of the hype they read about or hear in social media. Sometimes, they make decisions not scrutinized enough, and when it’s late, the market turns around on them, causing loss.
6. Hindsight Bias
Hindsight bias is the perception that past events were predictable. The trader tends to think he knew it all along when, in fact, he did not predict the outcome. Keeping a trading journal whereby you write down your reasoning ahead of the time a decision is made will help prevent this bias by making your thought process at the time of the trade clearer.
7. Survivorship Bias
Survival bias is when one focuses on the wins and neglects the losses, such as with investments. For example, if one is backtesting using only the stocks found on today’s list, one misses all the stocks that are delisted and most likely would have lagged behind. What this does is generate over-optimistic results of backtests that do not reflect real-world market conditions.
8. Gambler’s Fallacy
Gambler’s fallacy: The tendency to assume that previous outcomes in any way influence the probability of future events. For example, when a stock has increased three days in a row, a trader typically assumes it is “due” for a decline. In trading, you should be in a space of probabilities, not common patterns.
9. Status Quo Bias
The trader commonly follows techniques or strategies that had working market conditions in the past and will not alter them when conditions change. In this regard, he demonstrates status quo bias, which makes him incapable of adjusting and hence prevents him from finding new trading opportunities or changing his technique.
Trading Biases: Dealing with the Problem
Understand Your Trading Biases
But first, knowing that you are biased is only half the battle. The more you understand your biases in their manifestation in your trading behavior, the easier it will be to deal with.
Trade Small
One way of not having an emotional attachment to money is by trading small. This makes it easy for you to make strategic decisions rather than emotional responses to profit or loss.
Consider Algorithmic Trading
Algorithmic trading places that distance between you and your trading decisions. The computers service all of your trades; computer-based systems make buy or sell decisions, removing most emotional biases. This removes bias, not entirely, but reduces it well beyond the emotional cost of trading.
Put Checklists In Place
Just like checklists work wonderfully to prevent human mistakes in aviation, they could be effectively used in trading too. You can ensure that you don’t walk away from your strategy and make impulsive decisions based on the emotional reactions to create a trading checklist.
Conclusion
Trading biases are a lot of psychological traps of huge power, destined to undermine even the strongest trading strategies in perpetuity. Recognizing them-first and foremost, optimism, loss aversion, and confirmation bias–might just be the first step toward reducing their hold over the decisions made.
The most important learning for a trader is his own possible cognitive biases. Understanding them can make a trader very rational and significantly improve his performance in markets. Strategies to avoid this influence include trading small, algorithmic trading, or even working with some kind of checklist.