Trading is a wrestling match.
Traders have to wrestle with the market, wrestle with the constant cycle of information and data flow and wrestle with their emotions.
In many ways it is their emotions which pose the greatest risk to the long term success to most traders and investors because we all have cognitive biases which can work against our success.
These biases, first explained through the work of behavioural psychologists Daniel Kahneman and Amos Tversky, are common to all humans and some of them are the biggest barriers traders can face in sustaining long term profitability.
The key point is that we have natural instincts which inhibit our ability to do as economists and market efficiency disciples suggest and always make the “rational” decision.
All is not lost though as the research of Kahneman and Tversky spawned the birth of Behavioural Finance which has as one of its core tenets that we do not process information about risk, reward and uncertainty objectively.
It’s difficult to defeat these instincts when trading or investing. But knowledge is power.
Here are the top five cognitive biases you can control to be a better trader.
Like the picture you see in your mind when you read the term “anchoring” this bias refers to the tendency to anchor on the first piece of information you receive when making decisions.
In a trading sense this is important because traders often always “anchor” on their entry point rather than evaluate the market as new information comes in and prices react moving up and down.
A trader who buys NAB shares at $32 or the Aussie dollar at 93 cents will often anchor his or her beliefs about “value” at those levels regardless of new information and price action. This can lead to serious miscalculation and losses if not risk managed properly.
Overcoming this bias – a solid entry process coupled with known stop loss or take profit methodology.
Just like the Collingwood football club, the Australian cricket team, the Wallabies and John McEnroe, most traders hate losing.
But to be a successful trader or investor, taking losses is part of the process. You institute a trade place a stop loss, perhaps a take profit and you are away.
But Kahneman and Tversky showed us that “losses loom larger than corresponding gains”.
There are a couple of impacts this can have on traders.
The first is that newer traders and investors might have trouble “pulling the trigger”. That is fear of a loss means they can’t actually institute their plan to buy or sell the assets they are trading – or want to trade.
Losing money, in a controlled fashion, is part of trading and if this so paralyses a person that they cannot execute their trades then recognising that trading is not for everyone seems the right path to take.
But assuming that the hurdle of “pulling the trigger” has been overcome the second major impact of loss aversion is the way that many traders treat positions which go against them.
It is an axiom of trading that you should “cut your losses quick and let your profits run”.
Loss aversion – the inability to take a loss and the fear of losing a gain – means that traders and investors often do the opposite. That is, they “let their losses run and cut their profits short”.
It’s a recipe for losing a substantial portion of your investible funds.
Overcoming this bias – traders should not anchor on their entry point, they should have a solid entry protocol with a known value of their investible funds at risk on each trade and a preordained exit strategy.
Only then can you hope to overcome this most pernicious of trading biases.
Let’s face it no one goes into trading or runs their own investment portfolio without a little bit of self confidence in their ability to be a successful trader and investor.
But the behavioural psychologists tell us that anchoring and loss aversion overconfidence can add to a witch’s brew of negative biases likely to seriously impact on investment and trading returns.
Overconfidence can lead to increased trading volumes, increased trade sizes, “doubling down” where a trader adds to a losing bet, and under-reaction to important and game changing information. Overconfidence also helps feed bubbles.
Overcoming this bias – the biggest issue with overconfidence is that it can erode the decision rules associated with your investment and trading process, with your stop losses (doubling down means you are ignoring them) and your overall profitability.
As with the other biases and any business venture process is key. Entry, Exit, stop loss and trade management.
“When my information changes, I alter my conclusions. What do you do, sir?”
John Maynard Keynes
Lots of traders and investors are prone to this bias. They don’t do as Keynes exhorts but rather look for information which support their case.
Studies have shown that in aggregate markets can even be prone to only looking for data which support the case of the trader, his or her beliefs, trading/investment position or hypothesis.
In looking for data that supports their case traders ignore information which can affect their investments or trade.
This type of selective thinking is dangerous for traders but they must also ensure that they don’t fall prone to overweighting recent data in favour of the longer term importance of other information.
Overcoming this bias – traders just have to be objective.
They should evaluate fresh information when it is received not with reference to the entry point or anchor, not with respect to their expectation of how a market should move or trade but rather how, if, this new information effects the asset – stock, currency, commodity, bond – that they are trading or investing in.
If the facts change, then the position should be looked at with fresh eyes.
The bandwagon effect summarise the human tendency to want to conform, be part of the crowd, the do things because others are doing them or believe them.
This, associated with innate human greed, is how bubbles form and how the trading axiom which says that it’s not a top (in the market or bubble) until retail investors are fully invested.
Overcoming this bias – this one is simple. Have a solid investment process.
More Trading Insider:
- 4 Weapons Every Trader Should Have In Their Armoury
- Understanding ‘Black Swan’ Events, And How One Could Be Hiding In Plain Sight
- The Four Lessons From Enron Every Investor Should Understand