Last Updated on 7 September, 2021 by Samuelsson
Trading is not only about finding edges and inefficiencies to exploit in the market but also about understanding yourself because when your money is at risk, you can easily get fooled by your behavioral mistakes.
What is a behavioral mistake?
A behavioral mistake, also known as a behavioral bias or cognitive error, is the failure to think clearly because emotions are running high. It is a persistent deviation from rational thinking to making emotion-based decisions.
In his book, The Art Of Thinking Clearly, Rolf Dobelli defines cognitive errors as follows: “is a systematic deviation from logic – from optimal, rational, reasonable thought and behavior. By “systematic” I mean that these are not just occasional errors in judgment, but rather routine mistakes, barriers to the logic we stumble over time and again, repeating patterns through generations and the centuries. For example, it is much more common that we overestimate our knowledge than that we underestimate it. Similarly, the danger of losing something stimulates us much more than the prospect of making a similar gain.”
Behavioral biases are very much evident in trading as they are in every other aspect of life.
Why you should know your biases in trading
Knowing your behavioral biases is important in trading. It helps you to understand your limits and how you can improve your trading. But most importantly, it helps you to know how others think, as knowing the collective forces in the markets gives you an edge.
In The Disciplined Trader, Mark Douglas stated:
“Understanding yourself is synonymous with understanding the markets because as a trader you are part of the collective force that moves prices. How could you begin to understand the dynamics of group behavior well enough to extract money from the group, as a result of their behavior, if you don’t understand the inner forces that affect your own?”
If you’re loss averse, definitely many others are loss averse too. Hence, the more you know about your biases, the better you understand the psychology of the market.
The most common trading biases
There are numerous biases we can have about the market. These are a few of them:
- Optimism/Pessimism Bias: If you have been doing well, you’re likely to feel excited and optimistic. But if you’ve been performing poorly, you’re likely to feel pessimistic. Optimism can lead to overtrading, while pessimism can make you stop trading or tinker with your systems at the wrong time.
- Overconfidence bias: This is the tendency to overrate your knowledge and capabilities. You may think that you understand what’s happening in the market when you have no clue.
- Self-serving bias – “resulting”: This is the tendency to take credit for positive outcomes but blame others when the outcome is negative. A good decision can lead to a bad outcome, while a good outcome can come from a bad decision.
- Anchoring: This is the tendency to focus on certain types of information and ignore other sources. Anchoring often leads to the Martingale bias — doubling down to lower the cost price.
- Recency bias: Here, you tend to focus on the latest piece of information and ignore older.
- Loss aversion: This can make it difficult for you to execute your trading system even when backtesting shows that it can make money.
- Confirmation bias: This is the tendency to stick to information that confirms your beliefs. In trading, you don’t keep beliefs; you trade what you see.
- Gambler’s fallacy: This is the erroneous belief that if a particular event occurs more frequently than normal during the past it is less likely to happen in the future. In trading, you need to think in probabilities.
- Bandwagon bias (herd mentality): This is related to the fear of missing out (FOMO), which makes you want to follow the crowd.
- Familiarity bias: this is the tendency to use only strategies you are familiar with and avoid testing new ones.
How to overcome biases
Here are some tips that can help you overcome some of your behavioral biases in trading:
- Detach yourself from your money: Almost anyone can be successful in paper trading, but when real money is on the line, behavioral mistakes set in. To reduce your behavioral biases, detach yourself from your money.
- Trade smaller amounts than you’d like to: One way to detach yourself from your money at risk is to trade with a small amount you can afford to lose.
- Make use of quantified strategies (algorithmic trading): Algo trading offers the best way to minimize behavioral biases because the computer executes your trades. You don’t have to make trading decisions in the heat of the moment.
- Use a checklist to minimize unforced errors: Write down your biases and look for confronting arguments. Be your own devil’s advocate.
- Mindfulness exercises: Practice meditations every morning before approaching the market and always try to be in the moment by focusing on your breathing when you’re about to make a decision.