Trading is not easy: there are many factors and variables to keep track of. But it is also important to pay attention to trading psychology, as it may affect your decisions. Today we will talk about the 3 most common cognitive biases in trading that might influence your trading results.
What is a Cognitive Bias?
A cognitive bias is an unconscious error in thinking. It might occur when people try to process new information. Our brain does not like complexity, so it tries to simplify incoming information. It does so by interpreting the new data based on previous knowledge and experiences. This may negatively affect the decision-making process, including trading choices.
There are many different types of cognitive biases. Here are three that may be considered the most common and have a significant effect on trading psychology.
Confirmation bias
No one likes to be wrong. So sometimes people look for confirmation of their opinions instead of keeping a clear head and looking for facts. We dislike to second-guess and challenge our beliefs: it requires too much energy.
Imagine someone reading an interview with a famous actor they dislike. They think this actor is arrogant and self-centered. So every answer he gives will probably seem to support their existing opinion. It would be pretty hard to change it because confirmation bias works to maintain our beliefs as long as possible.
It is important to be aware of confirmation bias, as it might affect trading decisions. When making a deal, traders may sometimes overlook facts, because they go against existing opinions. So it might be useful to stick to factual information rather than personal beliefs. And even challenge yourself to look for reasons why you might be wrong in your current view of the situation to prepare for potential issues.
Charlie Munger, a billionaire investor and the vice-chairman of Berkshire Hathaway, said:
“I spent a lifetime trying to avoid my own mental biases. How do I do this?
1) I rub my own nose into my own mistakes.
2) I try and keep it simple and fundamental as much as I can”.
Gambler’s fallacy
This bias refers to an incorrect belief that some event in the future is more likely to happen because of past events. It is wrong because each situation should be considered independently, not based on what happened before.
A classic example to illustrate this bias may be a coin toss. When a person flips a coin, there is a 50/50 chance of both outcomes: it might land either “heads” or “tails”. But imagine if the coin was tossed 10 times in a row, and the result was “heads” 7 out of 10 times. What might be the probability of the coin landing on “tails” on the 11th toss? Some people might think that it is higher than 50%, when in fact it is not. There is still a 50/50 chance of each outcome because there is no connection between the past and future results.
Gambler’s fallacy might also play a role in traders’ decision-making process. For instance, a trader is considering trading an asset that has been losing value for a while. He or she may think “Well, it can not be going down forever, it will probably go up soon”. However, it would be wrong to make decisions based just on this idea. It might be useful to first get more information and consider using fundamental analysis and technical indicators before making a move.
Bandwagon effect
This bias is sometimes also called groupthink, as it refers to people following commonly accepted beliefs. It may be hard at times to resist the temptation to do as everyone does. We might think: “So many people just cannot be wrong, there is probably some truth in it”. This effect may lead to speculative bubbles and losses, so traders should be mindful of their tendency to follow popular opinions and try to keep an open mind.
How to fight cognitive biases in trading?
When making trading decisions, facts and logic may generally be considered more useful than assumptions and intuition. But even the most rational people should not ignore trading psychology, as it might still influence their actions. Cognitive biases are unconscious: they might endanger the accuracy of your trading decisions without you knowing it.
There is no certain way to prevent yourself from making mistakes. But being aware of these biases may help to prevent some of them. By carefully considering the factors that influence your opinions and challenging your existing beliefs, traders may avoid falling into the trap of their own biases. Practicing self-discipline may also be helpful: take a look at this article to learn more about this method: Cultivating Self-Discipline for Mindful Trading.
Conclusion
Cognitive biases might be tricky to control, especially for novice traders. So make sure that you are basing your trading decisions on facts and careful analysis, rather than on hunches. This way you might be able to avoid systematic trading biases that lead to common trading mistakes. To learn more about potential errors, check out this material 3 Top Trading Mistakes Novice Traders Make.
