15 Cognitive Biases Traders Must Know To Be Successful
Cognitive biases are insidious. As a matter of fact, they are probably affecting your trading profitability right now.
Here is a quick summary of the ones you must be aware of.
The tendency of our minds to fixate on a certain number and use it as a reference point to make decisions. For example anchoring on the entry price of a position, a price target, or high/lows on a chart.
2. Outcome Bias
Overly focusing on results over process; although the process is, more often than not, more within our ability to control than the outcome. For example, judging a trade to be “bad” because it lost money, instead of taking the time to understand if the process that led to taking the trade was sound.
Our minds are wired to feel the pain of loss more keenly than the joy of gain. This could lead us to fail to pull the trigger when it is time to enter into a position, and/or, fail to crystallize losses early.
4. Sunk Costs
Our human tendency to make decisions based on what has already been spent, rather than the implications for the future. This is dangerous as it can lead to traders failing to exit losing positions quickly for fear of “wasting” the non-crystallized loss.
The tendency to sell out of profitable positions too early, and hold on to losing positions for too long. This is one of the most common, and easiest ways, to blow up your trading account!
Viewing recent events as more significant, and therefore giving them more weight when making decisions, than those which occurred further in the past. This can lead to us drawing false conclusions about our trading performance and strategies.
People tend to believe in something simply because other people believe in them, which gives rise to herd behavior, market bubbles, and crashes.
It is always much easier to judge whether a decision is good or not in hindsight, even though the clarity of retrospection isn’t available to us when we are actually making the decision. Stop lamenting “I should have done this”, “ I should have done that”, “It could have been better; and instead develop the tools and methods to better manage uncertainty and risk.
Our tendency to draw conclusions from too small a sample of outcomes. This can lead traders to, after just a handful of trades, jumping to the conclusion that their trading strategy is good or bad, instead of waiting to see how it performs over a period of time that encompasses different market conditions.
The predilection towards seeking out information that confirms our views and opinions. This can lead to traders becoming overconfident in their positioning as the information sources they choose reinforce their beliefs instead of informing them of possible risks
Memories which, for whatever reason, are more firmly embedded in our memories are easier to recall, which influences our behavior. This could lead to traders becoming overly risk seeking/averse.
We tend to focus on success stories and overlook the information or lessons that can be learned from failures. This bias can skew our evaluation of the performance of funds and trading strategies.
13. Optimism Bias
The mistaken belief, held by individuals, that negative outcomes are somehow less likely to happen to them. This bias can lead to traders taking way too much risk on a single position, which can easily lead to them blowing up their accounts.
14. Narrative Bias
We have an innate need to seek explanations for events, the simpler the better. Unfortunately, this can cause us to fall into the trap of reductive thinking, and even lead us to believe in narratives which are inaccurate.
15. Halo Effect
The halo effect stems from our emotional reaction to our surroundings, and colors our perception and judgments accordingly. This often leads to black and white thinking where one side is always “right”, and the other always “wrong”, which fails to acknowledge that market conditions are always changing.
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