Make the most of your biases when trading stocks
Trading is one of the most brutal activities on the planet. There is little risk of physical damage such as a broken appendix or a punch to the face, but psychologically it can be difficult and sometimes even stressful. I have heard of traders who put their entire house deposit on the market and lost it; some have squandered their savings by betting on a single stock.
Trading can be profitable, but it can also be cruel. Sometimes you can do everything right and lose money. You may have an advantage, but nothing is guaranteed. Still, there are many things we can do to increase our chances of success. We can control our entries, exits, the size of our positions, how we manage risk, how we actively manage and monitor trade – as well as our mindset and psychology.
The best traders are able to control themselves. Many people believe that brokers, market makers and other market participants are their competition. But it is you who will break your own rules, lack discipline and succumb to the fear of missing out (Fomo). In this article, we take a look at eight of the most common trade biases and learn how to combat them.
Loss aversion is potentially the most threatening cognitive bias. Loss aversion is the theory that we feel the pain of loss twice as much as we feel the pleasure of gain. The theory is the result of the work of Daniel Kahneman and Amos Tversky, who are considered the fathers of behavioral economics (their work is worth reading for anyone involved in financial markets).
Loss aversion comes into play because we don’t want to sell losing trades or positions for fear of feeling the pain of a loss. But here’s the catch: if the market has marked your merchandise, you’ve already lost. There is a famous business saying that “it is only a loss if you sell”. It’s a fantasy. If it affects your net worth, it’s a real loss.
One way to beat loss aversion is to know your maximum risk before placing the trade and knowing when you will sell if the trade goes the wrong way (set a stop-loss). When the time comes, you just follow your plan and go out. Another way to combat loss aversion is to take small positions. Larger positions exaggerate our emotions, so the larger the position the more likely you are to be seduced by loss aversion and move your stop-loss lower. Before you know it, you can end up losing a lot more. Don’t take a stand without knowing your downsides and having a plan.
The player’s mistake
Gambler’s error is another common bias among new traders and investors. This happens when a person believes that after a series of losing trades they are more likely to be successful because they are “due winner”. Unfortunately, all trades are independent of each other. Just because you’ve lost ten trades in a row doesn’t mean you can’t lose ten more. Likewise, the chance of a coin landing on a tails after hitting ten heads in a row is always 50%.
Gambler’s mistake can often cause people to evaluate in order to fend off losses because they feel they must now win. Never be tempted to gauge when you lose – this only increases your risk and increases the chances of making mistakes.
Attribution bias describes a scenario in which marketers take credit for success but blame others when things go wrong. For example, after a losing trade, a trader who has a strong attribution bias may decide to blame their broker, the market or their keyboard, even if they have broken all of their trading rules and it is clearly their responsibility. mistake.
No one likes to blame themselves, but it is a fundamental principle that characterizes successful traders. Taking responsibility for your own decisions – even if the fault wasn’t really yours – is a great way to grow as a trader. Don’t fall into the trap of blaming others. Instead, think about what you could have done better.
The endowment effect occurs when we believe that something we own is worth more simply because we own it. Everyone thinks their house is the prettiest on the street. Every time we buy a stock, we value it more than if we didn’t own it. This means that we are at our peak when we have no position. Therefore, we need to do our research and plan our trading before taking a position. Once we press buy, we lose our objectivity.
The ripple effect makes it difficult for us to go against the crowd. Warren Buffett once said that to get rich you have to “sell when everyone is greedy and buy when everyone is afraid”. It’s easier said than done. Everyone wants to buy the dip until there is a dip. Everyone wants to go against the grain, but no one wants to risk losses. Opposites can look silly for long periods of time until they’re right, if ever they are.
In February 2020, when China closed its doors, I thought it was only a matter of time before Covid-19 reached other countries. Yet when Italy began to lock in, markets remained at record highs. It was as if the market had completely ignored the fact that we were heading straight for a global pandemic. I thought that selling the indices short and waiting for the market to react would be a great trade. If I was wrong, I could close the trade easily.
But I didn’t take the plunge. Why? Because the markets were at record highs. I thought if the smartest minds in the world dismissed the virus as nothing, then they must be right. Everyone was bullish and I dissuaded myself from selling the market heavily just before global stocks crashed. It is a lesson that I cherish and will always remember. Sometimes you have to get away from the crowd to outperform.
Recency bias is a cognitive bias by which we place more weight on more recent information and experiences. For example, a CFO leaving a company may cause some investors to sell. They think it’s a red flag, but if you look at most companies, it’s just noise in the long run. Recency bias causes investors to focus more on recent news, which ultimately has little impact.
Traders can also be victims of this bias. A trader with five losing trades in a row may decide that his strategy isn’t working because it hasn’t worked the last five times. But it’s just variance. Traders can overcome this bias by tracking their results and remaining confident in their advantage: their tactical or strategic approach which they believe tilts the balance in their favor over the long term. If you know your edge and have the discipline to follow it, it should give you the confidence to keep going and avoid recency bias.
Confirmation bias is a classic bias. Everyone likes to be right and no one likes to be wrong. But confirmation bias is dangerous for those who don’t know it, because we actively seek out information that tells us we are right rather than looking at the opposite point of view. Those who are strongly influenced through confirmation may attack others who have a different opinion. It is because they are so emotionally invested that their opinion becomes part of their identity. Bulletin boards are loaded with confirmation bias, with everyone singing from the same hymn sheet. Anyone who asks about the downside or posts a negative opinion will be attacked and reported.
When I was a new trader, I was part of a Twitter group full of shareholders from Cloudtag, a maker of fitness monitoring devices. The product had been delayed twice and I started asking questions – only to be removed from the chat. I then realized it was a total bubble and sold my shares by force, but unfortunately many shareholders still hold shares that were written off from brokerage accounts even today.
Confirmation bias is dangerous because it can cloud your judgment. Even those who are aware of the bias are not immune to it. The best traders actively seek out the downsides and what can go wrong because they know they are solely responsible for their results. The next time you find yourself in a trade, ask yourself, “What is the person on the other side of my trade thinking about?” Because there will be someone on the other side of your trade, and they might just be right.
Bias of the blind spot
Blind Spot Bias reflects how easily we can point out the mistakes and biases of others, but not our own. This is because we are detached from the situation and not get bogged down in so many details. This allows us to assess how badly they are. The problem with this is that we are unable to spot these same mistakes in ourselves and therefore we leave ourselves wide open.
One way to solve this problem is to team up with another trader and exchange ideas, notes, and trades. Your trading journal should also provide you with enough quantitative and qualitative data to enable you to discern the commonalities where you are wrong. Most traders don’t keep a trading journal, but most traders don’t make any money either.
Understanding and combating these eight biases will dramatically improve your trading. However, there are many biases and it is your responsibility to continue to improve your knowledge and manage your emotions effectively. For more information on biases, I would recommend Think, fast and slow by Daniel Kahneman.
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