This is second part of the article about cognitive biases. When any professional sportsman is interviewed, the first thing he talks about is often eradicating mistakes from his game. That is true of trading too.
You will get to know other cognitive mistakes which can affect your trading. The first step to fighting these bad habits is to know them better. That is why two articles were created.
Sunk cost fallacy
This bias is accurate for most people.
In general we are ready to stick with a decision even if the consequences are unfavourable.
There is also one more factor, the effort or cost of bad decisions can be high.
This is sunk cost fallacy.
In trading you can see this cognitive bias many times. One of the simplest mistakes is to run a losing position too long in the hope that it will reach profit eventually.
Often, traders move their stop loss further or do not use it at all because “the market must reverse eventually and I am already losing more than I should”.
It is no secret that very often this type of thinking brings massive losses or even losing the whole account If you use stop losses in your trading, you need to follow the consistently to eliminate this problem. Otherwise control of your account is impossible
Another example of sunk costs may be sticking to a trading strategy which totally does not suit you.
It can be a strategy which exhausts you emotionally, it may be created for other markets or it just simply does not work.
Despite that you still use it because you sacrificed so much time and money and it is very difficult to just leave it. You should know that cost in the past does not matter now and cannot be recovered.
When you are in situation of uncertainty and you make your decision based on readily available information, there is huge probability that you will suffer from anchoring.
How does it happen?
You will adjust your decision to the information you have. Traders very often may base their decisions on, say, the recent price. This price becomes some kind of anchor which can negatively affect their judgement. After a huge gain and creating new highs, a sharp fall makes the price seem too low.
Often this kind of anchor may be some information based on which you make an investment decision. Most of the times conclusions from this information are greatly simplified and adapted to your decision.
Traders affected by anchoring can make hasty decisions based only on this information. Their trading will be influenced only by anchoring.
People tend to look for information which confirms their assumptions and expectations. They do not focus on, and often reject, information that does not fit their beliefs. Especially when those assumptions were made with strong emotional impact.
Traders tend to give more value to information which confirms their analysis. On the contrary they tend to ignore analysis which does not meet their beliefs. Good traders should always have in mind that he can be wrong. It is really hard to be that flexible but it is worth a try.
This bias is also called gambler’s fallacy. It is based on thinking that independent events are dependent upon each other and making this decision based upon a small number of attempts.
People affected by conjunction fallacy often have a problem measuring the effectiveness of their trading system.
They often draw conclusions based upon just a few transactions which is an unreliable method which usually requires a bigger sample. As a result they often abandon good strategies just because there were few losing trades in a row. It is foolhardy to expect the results of a small sample to mirror those of a larger one.
In addition, every trade is an independent event, you cannot expect that after a series of losses next one will be profitable or vice versa. Let’s say your strategy has 50% efficiency – it means that half of your transactions will end with profit and half with loss.
You cannot expect that it will go like this: WIN-LOSS-WIN-LOSS-WIN-LOSS… It’s the same with thinking that after a series of losses there must be gain. This is always random and only big enough sample will give statistics for your strategy.
This is a very common cognitive bias.
You can notice it mostly during times of euphoria or fear invading the market.
In this case prices are rising or falling extremely fast and many people join the market just because others are doing that. They just follow the crowd. What is the result? Very often people join “the hype train” and open positions with a very unfavourable risk-return ratio.
In addition following the crowd does not lead to anything good and this type of behaviour does not develop professional approach to trading.
Realizing your motives can protect you from this kind of mistake. I assume that your trading plan does not have “buy because everyone buy” rule. Sticking to your plan will keep you from entering positions just because everyone do it. Remember, that there will be always some opportunity to invest money, you do not have to join the hype train.
Your strategy may very well throw out the signal that is driving the euphoria or fear but it needs confirmation and doing it because everyone else is, isn’t a confirmation!
Disposition effect happens when you rapidly close positions bringing profit and keep losing trades too long. This is directly linked with the desire to avoid losses. In case of winning positions trader is afraid of a reversal and losing all his profit. In the case of a losing position the trader hopes rather than expects that the price will finally move in his direction.
The best solution is to have strategy with clear take profit and stop loss rules.
You also have to stick to it and be patient, the position needs time to close at one of these levels (TP or SL). There is no need to break the rules you have created for yourself. You also have to remember that the risk taken in a position should not be higher than your comfort zone, otherwise, you will feel emotional pain and desire to manipulate transactions settings.