Although it is a sweeping generalization, it li likely that every trader at every level of knowledge and experience suffers from cognitive bias. That is the seeing reality for what we believe it to be for our own purposes and benefit.
Cognitive biases – what is it?
This whole attitude pervades whole portions of our lives; behaviour, emotions, opinions and analyses.
These occur most often during uncertainty which is an intuitive certainty. The more possibility there is of a wrong decision, the more likely we are to make one.
Studying cognitive biases should help us to avoid them.
The list of cognitive mistakes is long, in this article we will focus on few of them, directly connected with speculation:
- Loss Aversion
- Recency effect
- Sunk cost fallacy
- Outcome bias
- Confirmation bias
- Conjunction fallacy
- Bandwagon effect
- Disposition effect
Why should I care?
Awareness is all that is necessary. There is no intention to expect a whole new area to be studied and fully understood. These are problems that can happen and giving them a name helps identify them.
- The main answer to most of these cognitive problems is having a strategy and using it consequently. Of course the strategy should have positive expected value and be fitted to trader’s personality.
- Self-consciousness. Rather than spending hours contemplating an issue using emotions and needs, try to judge your situation. But give yourself all the time you need. Rash decisions are usually not high quality ones.
- A good solution to many problems is asking yourself: “Are my actions rational? Or maybe are they just a consequence of my emotional needs?” This kind of questioning yourself sometimes shows you that your thinking is not rational at all.
- Complete a journal for transactions and analyse them once complete. It is best to choose a set of transactions from last month, quarter etc. and repeat this process after ending the chosen period. When you analyse a position when it is already closed you are no longer emotionally connected to it and you can better identify motives of opening and managing it. If there were some cognitive biases during your trading, you will get really good feedback which will help you avoid mistakes in the future.
Simply put, loss aversion is a tendency to put more effort into avoiding losses rather than making profit. According to surveys, traders who make mistakes have twice as much psychological distress in case of loss than in case of missing profitable a transaction of the same size.
A trader who loses $1000 due to a mistake will suffer the same as trader who lost an opportunity to earn $2000 because of making error. When we look at this case rationally, both potential profit and real loss should be treated the same. This distortion often happens when trader makes a move not consistent with his strategy.
This effect is just a situation when you give more weight to the recent events/news/data.
The older ones does not interest you or they impress you less. In case of trading it is when you focus more on the recent trades than earlier ones. When you are affected by recency effect, you tend to be more worried about series of losses which happened in the near past and you do not remember about longer series of winning earlier.
This can lead to doubt about your strategy. In worst case scenario trader can drop the winning strategy and start to look for another one. Always remember about broad perspective of your trading and your strategy.
This is a tendency to judge transaction decisions based on its result rather than information known in the moment of opening position. As mentioned above, trading is an activity made living in an uncertain environment. Based on that there is no way to predict whether your decision will bring loss or profit. Even when your thinking in the moment of opening position was rational, it still can bring a loss.
Therefore the most important thing is to pay attention to the quality of the decision and not its effects. Traders affected by outcome bias do the opposite. It often leads to losing confidence and breaking the decision-making process or even a whole strategy. Focus on best possible analysis and execution of your strategy. Be aware that you cannot predict your result, do not think about it.