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Trading Psychology

7 Hidden Biases and How They Hold Back Your Trading

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Biases are like shortcuts for your brain. They can have an unusually large impact on how you make decisions in your everyday life, but particularly when it comes to your trading.

To put it simply, your brain has a way of conserving energy by making fast decisions or mental shortcuts in what are known as heuristics.

The problem is, we often don't even know that we have them. Even if we know about them, when it comes to trading, we have to work hard to challenge our reasoning behind making our decisions.

As common as these biases are, we specifically want to focus on what are called "cognitive" and "emotional" biases. These have been studied across psychology, economics and now into the mainstream of what is called "behavioural" finance.

Having seen these in my own trading and from viewing successful and less than successful traders, I thought it was worth highlighting 7 key biases that can (and likely will) impact your own trading. The question is, how many of these have you been a victim of and what can you do to try to prevent them?

1) Confirmation bias

Confirmation bias means we tend to seek out information that we agree with.

Ask yourself this question: How many times have you placed a trade then sat there and watched it go against you? OK, that happens a lot, no doubt, but then how often have you then gone out and sought information or headlines or "expert" advice about that currency pair which tells you why you were right and to just stick with it?

I remember many years ago, when I first started trading, I placed a fairly large trade on oil (I really couldn't tell you now why I made this trade - I had no idea what I was doing and it was too big for my account... Forgive me, I was just a beginner!) but as soon as it went against me I frantically typed "Oil" into Google, and just like that I was looking for any reason to support my original opinion on why oil was due to go up.

To my joy, there was so and so from XYZ Investment bank comforting me with a view that supported my own opinion or perspective. They talked about an undersupply in the market and that oil was sure to go higher. It was 2am by this stage as I watched my whole account go into jeopardy. This valuable advice that I sought helped me nurse myself back to sleep.

I, of course, deviously chose not to click on any article that might tell me I was wrong - I only sought out the information I wanted to hear or see.

Let's just say that the oil trade I placed went as well as a parachute made of concrete! (And my account was stopped out!).

2) The Endowment effect / Sunk cost fallacy

The endowment effect means we tend to value something more after we own it for a period of time.

In a now classic study, students were given a mug and were asked how much they would sell it for an equally valued pen as an alternative. The experimenters found that the median price for which they would sell was twice as much as they were willing to pay to acquire the mug.

Because of our aversion to losses, this can have a drastic effect on our trading success. We place a trade on EURUSD, which we were targeting a profit or loss of only 50 pips for. Yet when the trade starts to go against us, what's the first thing we often do? Move our stop loss further out because we "just know it's going to turn around." We tell ourselves stories like "The euro is cheap here, it'll definitely turn around."

Because we are committed to this trade (and this is somewhat related to the confirmation bias) we value it more just because we own it and because we have already invested in it, it becomes a "sunk cost".

3) Recency bias aka availability heuristic

The "recency bias" or "recency effect" essentially tells us that our recent experience can become the baseline for what is going to happen in the future.

This could be through our recent trade performance such as a recent win or loss impacting us heavily or a certain piece of news or information we recently heard forming the basis for our decision making.

For example, if I was to give you a list of items on a shopping list and then ask you to recall it, chances are you will tend to only really remember those items at the end of the list.

This can have seriously dangerous consequences for us as traders as it undermines our ability to form an objective decision on a trade. Why? Because we tend to focus too much on our most recent trade or information we found as a barometer for how the next trade will go.

Let's say you had a losing trade whereby you promised you'd never risk such a great amount of your capital again. You might be a little shy and dial back the risk a bit too much, or you could be the opposite and think you're George Soros, betting the whole house on the next trade since you just went so poorly on the last. Your thinking is this would get you back to where you were prior to your last trade.

The other way it can creep into your trading is through recent information impacting your decision on why to take a new trade. It might be that you see a brief news headline stating ABC bank's research on "why the dollar is going to dive this week" earlier in the day and tend to argue with yourself later that night why you think it's a good idea to follow that trade. I know what you might be thinking: "It's just a headline… I'd never let this happen to me". However, our brain has a lazy way of taking what it knows and ignoring the rest (as we have learned above).

We also have a tendency of the fear of missing out (FOMO as it's popularly known today) and with this new information we feel we must put something into action!

How to overcome the bias: As difficult as it may be, you have to stop and count to three and ask yourself a few questions.

These could be "why am I making this trade?", "Does it fit in with what I know?", "What am I missing here?", "Could there be a bias at play affecting my decision making?", or "How can I look at this objectively rather than emotionally and not let my recent trades/ideas affect my judgement?"

4) "The Gambler's fallacy"

The gambler's fallacy is where we believe that future probabilities are altered by previous events when in actual fact they're unchanged.

It is called the "gamblers fallacy" due to the often watched scene of a table game at the casino (the spinning wheel of the roulette table is a good one) as it landing on black over and over. People see this and think 'it couldn't possibly do that again' and try to bet against it.

As traders and human beings, we tend to believe that if something happens multiple times, it couldn't happen again. We ignore simple probability.

Let's say the S&P500 has rallied five days in a row. We place a trade in the belief that "it must be due for a correction" only to watch it rally and stop us out of our position.

It is important to look at the original reasons you wish to get into the trade. Just because something has moved up or down in a continuous fashion, it does not mean the market will immediately reverse its behaviour and go the other way.

5) The Bandwagon effect

The "bandwagon effect" is our inclination to do or believe things just because others do the same. Also known as "groupthink" or "herd behaviour", it can lead to having a serious trading hangover; ask yourself an odd question like "why on earth did I go long the EURCHF last night?"

A recent classic example was the first rate rise since 2008 by the Federal Reserve in December of 2015. Following the event, commentators and fund managers surveyed by Bank of America-Merrill Lynch said "buying US Dollars was the biggest one-way trade of 2016" and going against this trade would be like "the widow maker".

The majority of respondents and the general market consensus believed that as the Federal Reserve said they expected 4 rate rises in 2016 then the USD was surely going to rally.

Following that long USD trade would have led to some disastrous results. In fact, USDJPY fell from as high as 121 to 101 (an impressive 2000 pip fall since December) and as at the time of writing the Federal Reserve has not raised interest rates since.

Be careful of those bandwagons!

6) Hindsight bias

You could also call this one the "I knew it all along" effect. How many times have you heard someone say those words in life (not to mention in trading)?

We tend to believe that (of course much later than the event itself) that the onset of a past event was entirely predictable and obvious, whereas during the event we were not able to predict it.

Due to another bias (which we will not cover today) called "narrative bias" we tend to want to assign a narrative or a "story" to an event that allows us to believe that events are predictable and that we can somewhat predict or control the future. It allows us to try to make sense of the world around us.

It is now common to find stories of those who predicted the great recession and US housing bubble in hindsight. They become legends or "oracles" that people look to in the future for advice, believing they will again be able to foresee any future turmoil.

Why is this so important? The hindsight bias leads us into perhaps one of the most dangerous mindsets which is that of overconfidence, our final bias and probably one that is less hidden than the others.

7) Overconfidence effect

Overconfidence as a trader allows us to believe that we are superior in our trading, which ultimately leads to hubris and poor decision making.

Whether it's overconfidence on when to trade, what to trade (telling ourselves "sure I could normally trade AUDUSD, but why couldn't I also be good at trading the South African rand?") and how to trade a certain product.

We trade larger than we should, hold losers for longer than we should, relax our own risk management policy, become arrogant or complacent in our trading, and this all leads to capital losses.

What do I do now?

OK, so I might have scared you. You are now jumping at shadows and questioning your own trading decisions, believing you have all these secret, hidden disadvantages that you didn't have until 10 minutes ago.

Do not worry, biases can never be completely avoided. But we can work hard on challenging our opinions in order to make us more successful. Sometimes it's just taking the time to stop and think.

To help you along the way, we've created a possible checklist for making better decisions in your trading.

So stop, take a breath and ask yourself these 7 questions before you place your next trade.

  1. Why am I taking this trade?
  2. How strong is the evidence behind my decision to trade?
  3. Could I be missing something?
  4. Is there evidence to consider for the opposite side?
  5. Has the recency of information I've learned influenced my decision? If so, how much?
  6. Is this trade following the general consensus of the crowd? If so, is that a good thing?
  7. If none of questions 1-6 apply, then could any of the other biases above be at work?
Pepperstone
Pepperstone is authorised and regulated by the Australian Securities and Investment Commission (ASIC) and the Financial Conduct Authority (FCA). We take pride in our strong culture of regulation and compliance. The security of our client funds is of paramount importance. Pepperstone maintains segregated client accounts with National Australia Bank (Australia) and Barclays (UK).
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