What You Need To Know About The Anchoring Bias & Trading
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.
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