You are your own worst enemy when trading or investing in the markets.
Humans, in general, aren’t naturally wired to be good at assessing, and taking risks. A lot of this has to do with cognitive biases, which affect the ways in which we think and make decisions, often in very sneaky and insidious ways.
If you want to be a successful trader or investor, you will need to know what these biases are, how they affect you, and what steps you can take to mitigate them.
Our thought processes are notoriously riddled with cognitive biases. Which means that when we peer into our respective crystal balls to forecast the future, we only end up seeing a reflection of ourselves – what we want to see.
This psychological tendency distorts our thinking and the conclusions that we come to. In turn, this leads us to making poor trading and investing decisions. The best way to counteract this is to know how our minds work, and where our biases lie.
Here’s a list of the most common ones, how they affect us as traders, and what we can do to mitigate their effects.
A good way to understand the anchoring bias is to think of reference points that you compare future outcomes to.
In a trading context, this could be one or all of: the price at which you enter into a position, the price target(s) you set for a trade, recent highs/lows on a price chart.
Consider a scenario where a swing trader purchases stock in Apple at $145. He then sets a price target of $149.98, which was at the time of going long, the most recent high.
A few days later, Apple trades up to $149.82, which leads the trader to believe that the price target will be reached soon, and that he can exit his position with a quick profit.
However, over the next two days, Apple falls quickly down to the mid $142 level. What’s running through his head at this point?
A quick profit had suddenly turned into a quick loss after coming agonizingly close to hitting the price target. He thinks about exiting and taking the small loss, but after coming within a few cents of making a profit, is reluctant to do so.
His mind has naturally anchored itself on the price target, leading to his reluctance to close the position.
Moreover, with Apple in the $142s, he is now currently underwater on the position, which further adds to his reluctance to exit; especially when just 2 days ago it was profitable. At the very least, he thinks, it might be worth it to wait for the price to move back above $145, so he can break even on the trade.
His mind is now anchored to the price at which he entered the trade.
In both instances, anchoring bias prevented him from adapting to present circumstances. Instead of focusing on the pertinent fact that the position had turned against him, then taking steps to mitigate further losses, his thought process became anchored on:
1) What could have been (almost hitting the price target)
2) What he wanted it to be (breaking even on the trade)
This is one of the main reasons why more experienced traders keep harping on the importance of having a preset stop loss – when markets turn against traders, their minds end up working against them, not for them.
Our minds are clouded by the outcome bias when we are overly focused on the results of our actions, as opposed to the decision making process which led to them.
2. Outcome bias
Let us continue with the Apple trade example from our discussion on anchoring.
Imagine that our hypothetical trader decides to exit his position at $143, booking a loss on his trade (entry was at $145).
Outcome bias comes into play when he looks at the loss and thinks of the trade as a failure.
But, was it really a failed trade?
The answer to this question depends on why he exited his position. If he exited the position because Apple’s fall to the mid $142s exceeded the amount of risk he was willing to take on the position, then it wasn’t a failed trade.
However, if he exited because he was overcome by fear and had not decided beforehand how much risk he was willing to take, and what price reflected that level of risk, then it was a failed trade.
The key here is the process, or lack of one – the outcome isn’t relevant.
Why? Simply because the outcome of the trade wasn’t within his control.
No one can control what the market does, or how it moves. The best we can do is to manage how much risk we take so that if the position does move against us, it doesn’t wipe out too much of our capital.
In this scenario, if our trader succumbs to his outcome bias, he will not be able to see whether or not his trading process (if he had one) is working. This is especially so because he lost money even though the stock came so close to hitting his target and netting a quick profit.
Now let us imagine a second scenario where our trader decides to hold on to his position. Apple manages to stage a rally in the next two weeks that reaches his price target of $149.98, going as high as $151.68.
He dutifully closes out the position at his target and takes the profit. In this case, outcome bias kicks in when he looks at the profit he booked and considers the trade to be a success.
But, was it really a successful trade?
Like our first loss making scenario, the success of the trade needs to be judged not by its outcome, but by the process underpinning it.
In this case, the trade can be considered a success because the trader stuck to his plan.
Before going long Apple, he had already decided on a predetermined profit target, and when the market hit that level, he stuck to it instead of getting greedy and holding on. Conversely, should he have gotten greedy and decided to not take profits at his predetermined target, the trade would be considered a failed one.
It’s an extremely important point that’s worth reiterating – it’s the process that matters, not the outcome.
The vagaries of market movements leave so little of the outcome in our control, that the best way to trade profitably is to focus on how, why, and when we trade. Not whether our trades make or lose money.
Don’t let outcome bias blind you to what is truly important when trading or investing in the markets – your process.
The human mind is, generally speaking, inclined to prefer not losing, rather than winning. For some reason, psychologically, we are wired to feel the pain of loss more keenly than the joy of gain. Needless to say, this natural aversion to loss can have an outsized impact on our ability to trade the markets effectively.
3. Loss Aversion
Let’s play a simple game – we’ll flip a coin, and if it turns up heads, you win $110. If it turns up tails, you lose $100.
Will you take the gamble?
Logically, it is a good gamble to take, simply because the expected value is more than 1. That is, given the 50-50 chance of winning or losing, you stand to win more than you lose, $110 vs $100.
However, most people instinctively choose not to take the gamble. Why?
Because of loss aversion. In their minds, the discomfort of possibly losing $100 outweighs the happiness of possibly winning $110.
It is important to note that loss aversion isn’t a cognitive bias that is fixed at a certain level, like $110, for all individuals. Everyone will have a different number at which their decision changes.
The way to see this for yourself is to ask – instead of a chance to win $110, would you take the coin toss for a chance to win $120? If not, what about $150? How about $200?
In addition, the relationship between psychological distress from losses vs happiness from gains also isn’t linear, and is more like an “S” curve (sigmoid function). At any one point in time, every individual will have their own uniquely shaped S curve, reflecting their own preference for risk and reward.
That being said, as traders, it isn’t as important to figure out our own S curves as it is to understand how loss aversion acts against us when we are making trading decisions.
A good example of this is when it prevents us from taking trades that have the potential to be profitable.
To be continued…
How can loss aversion prevent us from taking profitable trades? Here’s an example that most traders can probably relate to.
3. Loss Aversion
Say for instance a trader is interested in taking a position in Facebook and assiduously follows how its stock trades over the course of six months. At the end of the period he has gained enough of an understanding of how the stock reacts to headlines, earnings and macro data to feel comfortable enough to put on his position.
Having seen FB make a bottom at $347.75, he decides to place an order with his broker that would get him long at $352. His rationale for doing so is that FB is trading in a strong uptrend, which makes $347.75 a possible area of support for a double bottom.
He chooses $352 as a possible future entry point to ensure that he can still enter the position even if the stock doesn’t fall all the way back down to $347.75.
Furthermore, he places a price target at FB’s previous high of $377.50, and intends to set his stop loss at $345. He does so to give the position some breathing room on the downside in case price falls below $347.75 (not making the double bottom), but catches a bid and rallies after.
With those levels, his trade has a reward/risk of ($377.5-$352) / ($352-$345) = 3.6; which means he stands to gain 3.6 times the amount he risks on the trade.
Finally, after working out his percentages, he decides that he’s comfortable risking $10,000 on the trade. This represents an amount that allows for substantial profit if the trade works out, but won’t take out a large chunk of his account’s equity if it doesn’t.
He has a good grasp of how FB is trading, has set predefined entry, exit, and stop levels in accordance with his risk management strategy, and has an excellent reward/risk ratio. It is, on paper, a great potential trade.
What could go wrong?
In a single word: execution.
When FB starts falling and moving closer towards his preferred entry point, instead of putting in the order to his broker in advance, he starts to have second thoughts.
What if the double bottom doesn’t materialize and FB’s price plummets below $345?
He would very quickly lose $10,000. While the amount isn’t a large chunk of his trading account, it still is a sizable amount of money to him.
Very quickly, his mind focuses on the potential $10,000 loss, instead of the reward/risk of 3.6.
He begins to think of all the things $10,000 can buy, the mortgage payments it can cover, the vacation he could go on. $10,000, in an absolute sense, is not a small sum of money for him to lose.
As his second guessing spirals into further doubt, he begins to question the soundness of his trading plan and decides to abandon the trade altogether – loss aversion dominates his psyche.
What happens after?
FB rallies strongly to hit his intended price target of $377.5 in just 7 trading days, and he can only sit, stare, and rue the what-could-have-been.
Of course, FB could just have easily plummeted past his stop at $345, in which case he would have felt justified in his decision to not put on the trade. However, in doing so, he succumbs to his outcome bias, instead of focusing on the fact that the optimal way to navigate trading uncertainty is by sticking to a well constructed trading plan.
Which he actually had before loss aversion clouded his judgment!
To be concluded…
Another example of loss aversion causing us to act against ourselves is when it prevents us from crystallizing losses when our positions turn against us.
Returning to our hypothetical trader and his position in Apple, loss aversion creeps into his decision making process when he has to decide whether or not to close out his position after it turns against him.
3. Loss Aversion
Having gone long at $145 and seeing the share price run just a few cents shy of his price target, Apple fell down into the mid $142 level, leaving him nursing a loss. At this juncture, he has to decide whether or not to hold on to his shares and wait/hope for price to rally, or take his losses and exit.
The logical approach would be for him to decide at what level he needs to exit the position, and from there calculate a risk-reward ratio based on his already determined price target of $149.98. If the ratio is in his favor, then holding on to his shares and waiting to see what happens is a logical thing to do.
If the ratio is not in his favor, then the opposite needs to be done – close the position and exit the trade. (Note that he really needed to calculate the risk reward ratio as well as the stop loss level before putting on the trade)
However, this simple decision is complicated by loss aversion.
Since closing out the position would make his losses real while simultaneously ending any hope of him being able to make money on the trade, his mind will be screaming at him not to do it.
This in turn exposes him to even more losses if prices continue to fall. Should this occur, and he allows the loss to snowball even further, he runs the risk of bankrupting his account!
Loss aversion, if left unchecked, has the power to dominate our thought processes and cause traders to lose money. Firstly by not taking potentially profitable trades, and secondly by causing small losses to snowball into massive ones.
The effects of this bias are insidious to any trader’s PnL, and as such needs to be actively guarded against. An effective way to do this is to maintain the discipline of calculating reward/risk ratios for every potential trade, and logging these ratios in a trading journal.
When this is done, a trader can get a good idea of how the potential profit of each trade stacks up against the risk that must be taken to achieve those profits. This in turn allows traders to quickly and easily compare the relative merits of different trades.
This process should imbue traders with some degree of confidence in their decision making process. Which can help ensure that trading decisions are made based on the relative merits of risk and reward together, instead of purely focusing on the potential of losing money.
Ultimately, the discipline of this process, when practiced repeatedly over long periods of time, can help all of us to better guard our decisions against our natural human aversion to loss.