What You Need to Know About The Outcome Bias & Trading
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.
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