Are You A Victim Of The Recency Bias When Trading? Part 1
While some cognitive biases, like the disposition effect, can be mitigated or at least guarded against by consistently executing a well thought out trading plan, others can’t.
A good example of which is the recency bias.
6. Recency bias
True to its name, the recency bias is the human tendency to view recent events as more significant, and therefore having more weight on today’s decision making, than events which occurred further in the past.
How can this negatively affect traders?
Consider a trader who has had the best six months of her trading career. All her trades over that period of time were profitable, her account balance is up by a substantial amount, and her confidence is sky high.
Why wouldn’t it be?
However, she is very cognizant of the fact that the sun doesn’t shine forever, and isn’t surprised when her winning streak ends with her first loss in half a year. She shrugs it off and actually feels more relieved than upset, since she no longer feels the weight of her six month winning streak on her shoulders.
Unfortunately, that first loss turns into a second, and a third, and by the end of the seventh month, her trading account is in a sizable drawdown.
Not sizable enough for the profits from her winning streak to be erased, but large enough for it to hurt.
At this point, she begins to doubt herself. What exactly is going on?
How did she go from feeling invincible at the start of the month to flailing around for answers at the end of it? Was the six month streak a pure fluke?
Is her trading plan as sound as she thought it was when all it seemed to do was churn out profits? More worryingly, if her trading plan isn’t as sound as she thought it was, what went wrong with it?
What does she have to change?
If left unchecked, these doubts can grow to become more harmful.
For example, our trader could start to question her own ability, and seriously start to wonder if she is “good enough”, or if she has “what it takes” to be trading the markets; perhaps causing her to abandon her efforts entirely.
These doubts are a product of her recency bias.
Recent losses hurt more than those which occurred long ago as their memory is still fresh in our minds. The psychological distress they cause, especially in a string of consecutive losses, naturally casts shadows of doubt in our minds.
This ultimately prevents us from seeing reality in a clear and objective way, which also reduces our ability to make sound trading decisions.
To be continued…
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