"To err is human" so goes a saying meaning that it is natural for human beings to make mistakes. While trading or investing we as humans make a lot of mistakes as we being humans are affected by cognitive biases. Here we are going to discuss ten cognitive biases.
Though we cannot altogether overcome these cognitive biases, we can definitely minimize their effects on our trading by being aware of them. Most of these biases are somewhat related to each other.
1. Anchoring Bias : Anchoring bias refers to giving too much importance to the first piece of information offered. For example a trading sessions was started off with a powerful bullish thrust and you were convinced that the session would be a bullish trend day. However the market showed clear signs of exhaustion, you continue to hold that it was bullish. You may find yourself fighting the market anchored by the bullish thrust.
In order to guard against this bias we must strike a proper balance between present information and historical data. Focus on what the market is telling you now without being stubborn.
2. Recency Bias : Recency bias as the name implies is giving more weightage to the most recent experiences. For example you lost money in three recent mean reversal traders hence you conclude that Mean Reversal is a losing strategy. And then you switch to Trend Trading.
Instead of deriving conclusion from the most recent experiences or outcomes we must examine them over a more extended period.
3.Confirmation Bias : As humans we hate the information or people that contradicts our thoughts.
We like them only when they confirm what we think. In other words we put more weight on information that confirms our position.
This cognitive bais is insidious. As we give more weight to things that confirm our thoughts, we become more confident. As a result, we become less aware of the fact that we are affected by confirmation bias. This bias leads to vicious cycle that ends in self-deception.
A classical explanation of the bias is that Bulls tend to remain bullish and bears tend to remain bearish regardless of what is happening in the market. To overcome the this bias we must avoid questions that confirm our own conclusion. Looks for Contrary advice or view.
4. Post-purchase rationalization: It is also known as Buyer's Stockholm Syndrome. Here one tends to rationalize and prove that the purchase is right however expensive or faulty it may be. For example a traders waits for a good entry or single trade that would make his day. But after getting into the long position the bias crept in and the trader rationalizes the long position despite several warning signs.
5. Bandwagon Effect : Bandwagon effect is based on the assumption that the opinion of the majority is always valid. We do things because everyone else seems to be doing it even there are no good reasons for doing so. For example everyone in your whats group tells you that Nifty will correct more than 20% and may touch 9000 before general elections of 2019. You look at the chart and find nothing bearish yes everyone is saying so you sell all your holdings.
Remember trading or investing is a lone voyage. To be successful in trading one must ignore the noise and herd mentality. Avoid watching CNBC.
6. Attribution Bias : When things go well, it is because of me. When things go south, it is definitely not me. When you make a handsome gain on a trade you start to feel like a genius attributing that victory to your extraordinary trading skill. However when you make a loss on a trade you blame your broker, your computer etc. We must take responsibility for what went wrong and try to learn from our mistakes.
7. Loss Aversion Bias: This is a very simple yet the most powerful bias. The key idea here that people react differently to positive and negative changes of their status-quo. The pain of loss is twice the pleasure of equivalent gain. A simple example of loss aversion : If one offers a gamble (a coin toss) with 50-50 chances of winning Rs.100 & losing Rs.75, a loss averse person will not accept it despite the fact that the gamble has positive expected value.
Another important concept related with loss aversion bias is the Disposition Effect. People hold on to their losing position while get out of the winning ones.
8. Illusion of Control : This bias makes us think that we can control the events when in reality we cannot. The outcome of any particular trade is random and we cannot control it. The focus should be on what we can really control, for example, Position size.
9. Hindsight Bias : In simple terms we can describe the bias as " Maine Bola Tha" ( I had told you earlier). Hindsight bias is the inclination after an event has occurred to see the event as having been predictable, despite there having been little or no objective bias for predicting it.
10. Bias Blind Spot : You see that other people are biased but do not realize your own cognitive biases. After reading this article you watched your friend trade. In your mind, you thought that he was wrong to do this. That's the disposition effect. But when you review your own portfolio you may find fewer biased decisions.
Conclusion : Don't worry about these behavioral biases else you may become totally indecisive. As mentioned they cannot be avoided so we must accept them and understand them so that we can atleast minimize their effect. Accepting our imperfection as a trader or investor is the best solution.
Though we cannot altogether overcome these cognitive biases, we can definitely minimize their effects on our trading by being aware of them. Most of these biases are somewhat related to each other.
1. Anchoring Bias : Anchoring bias refers to giving too much importance to the first piece of information offered. For example a trading sessions was started off with a powerful bullish thrust and you were convinced that the session would be a bullish trend day. However the market showed clear signs of exhaustion, you continue to hold that it was bullish. You may find yourself fighting the market anchored by the bullish thrust.
In order to guard against this bias we must strike a proper balance between present information and historical data. Focus on what the market is telling you now without being stubborn.
2. Recency Bias : Recency bias as the name implies is giving more weightage to the most recent experiences. For example you lost money in three recent mean reversal traders hence you conclude that Mean Reversal is a losing strategy. And then you switch to Trend Trading.
Instead of deriving conclusion from the most recent experiences or outcomes we must examine them over a more extended period.
3.Confirmation Bias : As humans we hate the information or people that contradicts our thoughts.
We like them only when they confirm what we think. In other words we put more weight on information that confirms our position.
This cognitive bais is insidious. As we give more weight to things that confirm our thoughts, we become more confident. As a result, we become less aware of the fact that we are affected by confirmation bias. This bias leads to vicious cycle that ends in self-deception.
A classical explanation of the bias is that Bulls tend to remain bullish and bears tend to remain bearish regardless of what is happening in the market. To overcome the this bias we must avoid questions that confirm our own conclusion. Looks for Contrary advice or view.
4. Post-purchase rationalization: It is also known as Buyer's Stockholm Syndrome. Here one tends to rationalize and prove that the purchase is right however expensive or faulty it may be. For example a traders waits for a good entry or single trade that would make his day. But after getting into the long position the bias crept in and the trader rationalizes the long position despite several warning signs.
5. Bandwagon Effect : Bandwagon effect is based on the assumption that the opinion of the majority is always valid. We do things because everyone else seems to be doing it even there are no good reasons for doing so. For example everyone in your whats group tells you that Nifty will correct more than 20% and may touch 9000 before general elections of 2019. You look at the chart and find nothing bearish yes everyone is saying so you sell all your holdings.
Remember trading or investing is a lone voyage. To be successful in trading one must ignore the noise and herd mentality. Avoid watching CNBC.
6. Attribution Bias : When things go well, it is because of me. When things go south, it is definitely not me. When you make a handsome gain on a trade you start to feel like a genius attributing that victory to your extraordinary trading skill. However when you make a loss on a trade you blame your broker, your computer etc. We must take responsibility for what went wrong and try to learn from our mistakes.
7. Loss Aversion Bias: This is a very simple yet the most powerful bias. The key idea here that people react differently to positive and negative changes of their status-quo. The pain of loss is twice the pleasure of equivalent gain. A simple example of loss aversion : If one offers a gamble (a coin toss) with 50-50 chances of winning Rs.100 & losing Rs.75, a loss averse person will not accept it despite the fact that the gamble has positive expected value.
Another important concept related with loss aversion bias is the Disposition Effect. People hold on to their losing position while get out of the winning ones.
8. Illusion of Control : This bias makes us think that we can control the events when in reality we cannot. The outcome of any particular trade is random and we cannot control it. The focus should be on what we can really control, for example, Position size.
9. Hindsight Bias : In simple terms we can describe the bias as " Maine Bola Tha" ( I had told you earlier). Hindsight bias is the inclination after an event has occurred to see the event as having been predictable, despite there having been little or no objective bias for predicting it.
10. Bias Blind Spot : You see that other people are biased but do not realize your own cognitive biases. After reading this article you watched your friend trade. In your mind, you thought that he was wrong to do this. That's the disposition effect. But when you review your own portfolio you may find fewer biased decisions.
Conclusion : Don't worry about these behavioral biases else you may become totally indecisive. As mentioned they cannot be avoided so we must accept them and understand them so that we can atleast minimize their effect. Accepting our imperfection as a trader or investor is the best solution.
