Why Successful Traders Cannot Afford To Be Too Optimistic
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.
Remember Pareto!
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