Cognitive BIases

In order to trade at the highest level, it’s imperative to know the internal factors that can affect your decision-making. Awareness of these biases can and will bring you closer to reality as well as possibly reduce mental fatigue and stress. 

 

  1. Gambler’s fallacy 

 

  1. If a roulette wheel lands on black 5 times in a row it has to land on black again, one erringly believes that it is guaranteed to land on black again. 
  2. If a roulette wheel lands on black 5 times in a row one erringly believes that it’s due to land on red because of reversion to the mean. 

 

Both of these assertions are probabilistically-speaking, plain wrong on a fair roulette wheel. An event occurring in the past does not confer a 0% or 100% chance of that event occurring again. If you ever believe that a certain event in the market is guaranteed to happen, know that absolutely nothing is guaranteed. Moreover, the two best tools that you have in your arsenal to fight against this bias is probability (as outlined in this course) and a solid understanding of what a strong/weak uptrend/downtrend looks like. 

 

       2. Confirmation bias

 

  1. You believe that your city is getting younger. Due to this thought, you begin to only notice new information that supports your initial claim ie. you solely notice younger people and ignore older people. 
  2. The initial assertion that forms a confirmation bias can come from the smallest of sample sizes, but once it takes hold in the brain it can be quite difficult to think differently. 

 

Confirmation bias occurs when one searches for and remembers information that supports their initial assertion, whilst ignoring and forgetting information that contradicts their initial assertion. This is incredibly common in markets, and whether they know it or not it occurs to just about everyone. 

 

To avoid confirmation bias, if you are in a position ask yourself the question: If I wasn’t in a position would I still enter here? 

 

If you would not enter with the current price action of the timeframe relevant to you, look to reduce/exit your position. 

 

Another method to avoid confirmation bias, is to again stick to purely a probability model of the market. In fact, a good strategy you can use to reduce heuristic/biased thinking is to use probability and statistics when thinking about the market. 

 

       3. Loss aversion 

 

  1. You make 500 USD on a trade in 2 days and then lose 500 USD on a trade a day later. After the profitable trade, you felt moderately elated but after the losing trade you feel devastated. 
  2. This is an incredibly common emotional response as psychologists have found that losses hurt emotionally 3x more than gains. 

 

Loss aversion is a feeling that many traders know all too well. It can lead to traders taking marginally small profits due to fear of incurring a loss on a trade. A good way to avoid making poorly informed choices due to loss aversion is to set your limit buy/sell orders and if you are trading with a longer timeframe — just stay away from charts and market monitoring. If you use a medium to shorter timeframe this might not be possible, but know that you should only shift orders if your bullish/bearish bias fundamentally changes. 

 

        4. Social proof

 

  1. You notice that many of your trader friends believe that Bitcoin is about to drop rapidly in price. Even though your bias was bullish, you decided to sell your holdings. Bitcoin rises and you look back and regret your decision. 
  2. Social proof takes over when you decide your analysis based on what people are saying. 

 

Never forget that markets tend to trend opposite of investor’s expectations, stick to your own analysis. If you look at patterns of investor’s sentiment and expectations of the market vs what actually happened, you will see just how often investors and traders get it wrong. 

 

        5. Black-or-White Thinking 

 

  1. You see the market falling in a strong sustained downtrend that’s lasted over a month, and you believe that it is physically impossible for the market to rise anytime soon. 
  2. This bias is a mix of the gambler’s fallacy and confirmation bias. It’s a type of thinking that is very easy to fall into, it’s important to note that this is non-probabilistic thinking. 

 

error: