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.
Do you believe that negative outcomes are somehow less likely to happen to you? Because most people do.
They believe that they are likely to live longer than the average person, less likely to get divorced, less likely to get into a traffic accident, etc.
But, not everyone can consistently be above average, and traders who like to think that they are quickly find out otherwise – often in very painful ways.
13. Optimism bias
This mistaken belief is known as the optimism bias, and while optimism can be useful in helping us get through difficult periods in life, it can lead to disastrous consequences for traders who allow themselves to be blinded by it.
A good example of this is the tendency for novice traders to go “all in”.
The allure of betting one’s entire trading account is that it creates the possibility of earning a lot of money very quickly. The downside to this is that it also opens up the possibility of one losing everything.
Inexperienced traders tend to trade in this manner often, and are more likely to do so in markets that are making big moves, with high levels of volatility. These types of markets offer the greatest possibility of making the highest amount of profit in the shortest amount of time, and thus tend to attract traders looking to make a quick buck.
Unfortunately, once the almost irresistible carrot of “get rich quick” is flashed before people’s eyes, most get swept away by their optimism bias, and mistakenly believe that the odds of them getting rich quickly are higher than they actually are.
Subsequently, big bets are placed, and more often than not, a lot of money is lost.
Not just because the “get rich quick” opportunity fails to turn into something concrete; but also because inexperienced traders have no idea what to do if they actually make a lot of money on the trade.
Instead of quickly cashing out, most get greedy and hold on to their positions for way too long, or even add to it. Reddit’s adventures in Gamestop are a good example of this.
However, the optimism bias doesn’t only apply to “all in” trades. They apply to all instances where traders risk too much on a trade, to the point where a loss pushes their account balance below where they can realistically take prudent risks to make back what they lost.
A simple way to see this is to understand that a trader whose account is down 50% must make a return of 100% in order to make back his losses, which is an extremely difficult feat to accomplish.
Ironically, a novice trader in this position is more, not less, likely to succumb to the optimism bias and take outsized risks in order to quickly make back the 50% loss. More often than not, this only ends up in him making even larger losses.
That being said, the best way to guard against the blindness induced by the optimism bias is to first have, then consistently follow, a well constructed trading plan. This is due to the fact that having such a plan, and having the discipline to follow it, precludes traders from taking large risks, which in turn greatly reduces the probability of traders blowing up their accounts with just one very bad trade.
Humans have an innate need for explanations. In our minds, every effect must have a cause, and we naturally seek out reasons for events that occur.
This is part of a broader narrative bias, and while useful in simple scenarios, it can be dangerous when applied to complex systems like financial markets.
14. Narrative Bias
This danger stems from us falling for false narratives, that is, narratives that are constructed out of the need to “scratch the itch” of our need for an explanation.
Just think of the last time you came across a headline that followed this simple formula: Market goes up/down because [some reason].
For example, “Market goes down on fears of Fed hike”, or “Market goes up on the back of stronger economic data”.
The financial media produces dozens of such headlines on a daily, and sometimes intraday basis, always attributing market movements to a single, simple, cause. Unfortunately, reality is a lot more complex, and most of the time, we simply cannot say what caused the market to move up or down.
For example, the headline “Market goes down on fears of Fed hike” implicitly assumes that the Fed raising interest rates is a negative for markets, when in truth, this isn’t always true. The logic applied by whoever wrote the headline runs along the conventional line of thinking that higher rates increase the cost of funding and hence lowers economic growth and equity valuations.
However, we know from the interest rate fallacy that this simply isn’t the case, and that higher rates are actually a byproduct of higher growth and increased business confidence, which, if anything, are indicative of higher stock prices.
Consequently, the narrative espoused by the headline is false, and people who read the headline (and possibly the article) will be led to mistakenly equate rate hikes with lower equity prices!
Moreover, daily trading volume for US equities is in the hundreds of billions, which makes it quite unlikely that stocks will move higher or lower because of one simple factor (the obvious exception to this is a financial crisis, where everything is falling because of fear based selling).
After all, the stock market has myriad participants, each with their own reasons for buying or selling. Which means that the only statement that can be made with accuracy is: Stocks are higher because more people are buying than selling, and vice versa.
Unfortunately, the explanation provided by this statement fails to capture the imagination (some might not even consider it an explanation), which would explain why it is never used.
Furthermore, financial markets are complex systems, and while its short term movements can be random or influenced by events, there is often a lot more going on. Since headlines tend to focus on short term market movements and events, it isn’t surprising that they conflate both into a cause and effect relationship.
However, in doing so, they ignore information which is much more important like the context behind the price move. This context is more often than not the market’s longer term trend; and if stocks are trending lower, it is quite likely that prices on any given day will fall, regardless of a Fed hike.
Therefore, when we succumb to our narrative bias we not only fall for false narratives, we also fall into the trap of reductive thinking, both of which can lead us to trade on information that is incomplete and/or inaccurate.
Beware your narrative bias!
The problems posed by the Narrative Bias are exacerbated by our human tendency to go emotionally “all in” on something – we either fully like it, or fully dislike it.
This is known as the halo effect, and leads to black and white thinking that can be counterproductive to traders.
15. Halo Effect
The halo effect stems from our emotional reaction to our surroundings, and colors our perception and judgments accordingly.
Celebrities provide a good illustration of this, where people tend to have favorable opinions, or tend to attribute positive traits to them, simply because of their physical appearance.
If you think about it, it isn’t difficult to come to the realization that this makes no logical sense, since very few of a celebrity’s fans actually know the celebrity personally – their rose-tinted view of the celebrity is colored by the halo effect.
The same thing happens with politicians, where supporters tend to fixate on favorable first impressions. If someone thinks that a politician’s physical appearance is attractive, the halo effect kicks in and everything the politician says or does is always thought of in positive terms.
However, it doesn’t always have to be about physical appearance.
If something a politician says at a rally evokes a strong emotional reaction from the audience, the halo effect can also kick in and cause them to view the politician more favorably.
This naturally leads to the polarization of opinion, with those who agree with the politician giving their fervent support, and those who do not, their complete disapproval.
The political climate in America today is an excellent demonstration of this “us and them” thinking – which is a hallmark of the halo effect.
The same polarized thinking also occurs in financial markets, and is most easily observed in how they coalesce around financial “gurus” and the narratives they espouse.
Good examples of this include diehard goldbugs and crypto evangelists who refuse to consider opposing viewpoints – to them, they are “right”, and everyone else is “wrong”.
Needless to say, this is fertile ground for the confirmation bias to take root, which is exactly what happens, with the resulting formation of ideological echo chambers.
A more nuanced way of thinking, and one more reflective of how the world works, is to consider the circumstances with which a particular narrative can work, and the circumstances with which it cannot.
For example, cryptocurrencies are not an uncorrelated asset, but, depending on the point in time, can be a more effective inflation hedge than gold. This certainly turns the conventional narrative of gold being the go-to inflation hedge on its head, while also disputing the claim that cryptos are good portfolio diversifiers.
Who knows how this will change in the future?
Getting sucked into the halo effect is to fail to acknowledge that market conditions, and the relationship between market and economic variables, are always in flux.
If a trader or investor only ever sees one point of view, he will only ever position himself in one direction.
A goldbug will only ever be long gold, and a crypto hodler will only ever be long crypto – often with disastrous results when market conditions change for the worse!
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.