The bad news is that you will never entirely overcome your cognitive biases, because it’s in our nature as humans. The good news is that once you are aware of your cognitive biases, you can stand a better chance at becoming a successful trader.
Today we’ll work on our trading mindset and you’ll discover the most dangerous mistakes you make in your decision making process and you'll learn how to correct them.
So what is a “cognitive bias”? I’ll will try to keep is very simple and not over complicate the concept. A cognitive bias is just a bent that leads our thinking faraway from an accurate judgment.
Here, are the foremost important biases that each trader or investor can relate to.
1.CONFIRMATION BIAS
So, let me take you as an example.You see a stock trending on social media.The stock has already gone up 300% in just couple of weeks, as the company announced a new product they're currently testing,that is showing great promise. You recall this company being mentioned on CNBC or Bloomberg a few of days ago. You go and “google” the company and looks for articles that would suggest the stock might keep on increasing in price. You find some articles confirming that the company's new product will be a hit worth billions of dollars. You read all the positive comments about that company on different social media platforms. You then look at the chart and although the stock doesn’t fit your technical criteria and may be overextended or overbought, you recall that some TV analyst predicted a price of is $30 per share and the stock is now trading at 10$ per share, so likely to at least triple from there. You decide that all stars are aligned and this is the perfect chance. You put all your savings in the stock and start thinking about the things you will buy with the profit.This is the confirmation bias:
A tendency to actively seeking only information that confirms your beliefs, and you reject or disregard information that dis confirms your beliefs. We all experience confirmation bias.How to overcome it?
It’s hard and it’s up to you to recognize it and be aware that it affects your decision making process.The first thing i do every time I enter a trade is to make a list of the pros and cons and reassess it with an open mind. Always consider the other side of the trade you take.2.SELF-SERVING BIAS
Let’s continue with your story. In the next days, the stocks decreases in value, and goes against your position. Not only you have a losing position, but the stock keeps going even more against you. However, you still believe that your reasoning's still correct. After all, you did some research, and TV analyst sand social media confirmed your view. You are absolutely convinced that you aren't wrong. The ones that sold the stock are just amateur sand are selling the opportunity of a lifetime. You think to yourself that the stock is probably being manipulated by investors wanting to buy some more shares at a lower price. You know that the stock will recover as soon as the market finally understands how company will be worth billions in the near future. You see the problem here?You can only see information that fits your puzzle, regardless of whether the puzzle is correct or not.This is the self-serving bias:
A tendency to focus your attention on the information that enhances your self-esteem and protects you from any negative feedback. Self-serving bias is also known as the attribution bias in some books. Basically, when things go well, it is because of you. When things go south, it is definitely not your fault. Come on, admit it: after a fantastic trade with a nice profit, you start to feel like a genius, thinking that your trading skills made it possible. After a losing trade, you blame your broker,your computer, your chair, your zodiac sign. That’s the self-serving bias.The lesson here is to assume responsibility for everything, including your losses. As a trader or investor, try not shift blame because it does not help you progress. What does help? Taking responsibility to find out what went wrong. And doing what is needed to improve.
How to overcome it?
Consider keeping an investment or trading journal. Reviewing a trading journal can help you easily identify strengths and weaknesses in your trading. It can also help you identify mistakes that you continually make. Also, it can assist you to spot when and why your analysis was correct.
3.HINDSIGHT BIAS
The stock fell from 10$ to $3 and your trading account gets a margin call. Unable to cope with the pain of that loss anymore, you finally realize your mistake. You start to recall all the red flags you noticed before buying the stock. You remember that you saw many articles saying the company’s product was not ready yet and the chances of releasing it were slim. And on top of that, the stock was clearly extended once you entered the trade. After reflecting about it, it was clear in your mind that you knew this trade was going to be a loser right from the start.
This is the hindsight bias:
A tendency to represent the past not according to what you experienced, but according to what happened later. So basically hindsight bias can lead you to believe that an event was more predictable than it actually was. 4.RECENCY BIAS
After a week, you see another opportunity. Another company, from the same sector. There’s a lot of hype on social media about this stock. It even fits your technical criteria, a no-braininess. But you lost money on the previous trade. Due to your recent experience, you decide to skip that opportunity, you’re afraid.This is the recency bias:
Our brains naturally put more weight on recent experience and we avoid trades that remind us of our recent losses.How to overcome it?
Write out a trade checklist with your criteria from your trading plan. This way, you are more likely not to enter every trade unless it fulfills all of the criteria. You will enter a trade only if it matches your trading plan criteria, no matter if you had a losing or a winning trade before.
5.ILLUSION OF CONTROL
You think that you can control if your next trade is profitable and everything is under control. You are convinced that you have control and that's why you increase your lot size. Nothing can go wrong. Thinking that you can control the outcome of your next trade, is the same as believing that you control the market. You clearly don’t. The illusion of control comes after a winning streak, and is extremely dangerous. You increase your lot size and when the trade goes against you increase your stop loss, because you absolutely know that you're right. And, you guessed it; you get a margin call after a winning streak. One bad trade can wipe out your entire account. The market doesn’t care you won 10 trades in a row. We work in uncertain conditions.
Recognizing that we've no control over the market is that the initiative towards managing our risk. The lesson here is to avoid seeking certainty and control. That’s why it’s better to focus on controlling what we can control. Our actions and emotions.
6.BANDWAGON EFFECT
You buy a stock because everyone else seems to be doing it, even when there are no good reasons for doing so. Another example is when you hear everyone saying that the bull market will stop soon. You hear words like recession and bear market. The news, gurus, and forums are all bursting with negativity. You look at your charts with your technical analysis tools and you don’t find anything bearish. Then you look at several stocks and find some bullish setups. But because everyone was saying that the bull market would come to an end, you sell all your long positions and skip new long trades.The outcome of the market does not matter,whether it continued to rise or fall. You have already joined the bandwagon bias because you follow the herd instead of your analysis.
The lesson here is to listen to your own analysis,and ignore the voices of the masses. I’m not saying you should adopt a contrarian mindset and always go against the herd. That is not the case. Just trust your own analysis.
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