Decisions, decisions...Buy or sell? Take a profit or let it ride? Whether we like it or not, making good, well informed decisions is an essential part of successfully trading and surviving the stock markets.
Whatever the case may be, good informed decision making is important. It's not enough to rely on just luck or guesswork. This disguises poor decisions, reinforces your trading biases, and ultimately costs you dearly.
What you have to understand is that our actions and opinions, from all the decisions we make, are shaped by reason, emotions, memories and different types of bias. Some of which are made unconsciously, while others play on our minds, in a kind of mental tug of war.
Anyone who has experienced wrestling with the emotions of fear and greed when trading, will understand this emotional battle.
Of course, it would be great for us as traders, to be able to totally detach ourselves emotionally. Everything would be so much easier. So its hardly surprising then that the best traders are those that come close to achieving this state of mind.
But...we also have to realize we are human beings not emotionless machines. So no matter what, emotions and cognitive bias will always play a part in the decision making process.
In this article I take a look at what I consider to be 10 of the most common types of bias that in my experience have the greatest negative impact on most peoples trading.
I am going to show you the characteristics of each, their effects on your trading and provide some solutions that I hope will help you more effectively deal with them.
The 10 Most Common Types of Bias.
1. Optimism bias
In common terms this is called "wishful thinking" where the probability of a good outcome is overestimated above that of a bad one.
Over-optimism is commonly seen in the form of large price moves and over reactions in the market. These are fueled by feelings of uncontrolled optimism that become contagious amongst traders.
It is not uncommon to see these reactions right at the top of a stock or market run and they are usually accompanied by plenty of good news..
- Lead you to take a larger trading position than you should
- Buy in an area of high risk
- Delay cutting your losses
The first step to coming to terms with any types of bias is to be aware of them and accept that they are real.
In the case of optimism bias because there is a tendency to be overly keen and jump into trades without much thought, it is essential that a trading plan be formulated. It's really important that you provide a framework for yourself to keep your over-enthusiasm in check.
Keeping a trading journal is also a great idea, so you can review your actions and see where you have gone wrong. A big problem with having an optimism bias is the tendency to not want to face up to losing situations and their causes.
Unfortunately these tend to be ignored and put out of our mind in order to protect our self belief. This in turn compounds the optimism bias.
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2. Overconfidence bias
At first glance this would appear to be similar to over optimism, but there are some big differences. The main one being that it is entirely possible to be an over-confident pessimist.
This is more common among traders who consider themselves experts. Novices tend to harbor a general lack of confidence until they get a few good trades under their belts. They do have to be careful though that as their confidence increases that they don't wipe out their trading account.
This is a pretty common occurrence once traders start to believe that they are invincible.
The truly ironic thing about this particular bias, is that we need a degree of confidence to trade well, but too much of it and our account suffers.
Interestingly female traders do much better than male traders because of their tendency to have lower confidence levels. This makes them more cautious, they don't get caught up in the trap of over trading and because of this they generate much better returns.
- May make you overestimate price targets & profits
- Believe you are better than everyone else
- Take on too many trading positions
- Take positions that are too large
Try and focus on what you could be doing better, not on how good you think you are. Remember overconfident traders don't last long. You may be lucky and do well for a while but ultimately your overconfidence will affect your judgement and hurt your account.
3. Confirmation bias
This is the desire to find or search out information that agrees with your own views and can be a critical element in poorly interpreting your view of a stock chart.
A perfect example of this might be the trader who believes the market may drop because he watches the news and has an overall negative view. He will then focus only on the stocks that support this view. In the meantime, as is the way of the markets, they move up to new highs and he/she misses it.
- The tendency to place a lot more importance on information that confirms your position
- Leads to self deception
Open you eyes to the bigger picture and search out as many possible alternative scenarios to your situation as you can. Try and take the alternative view and prove yourself wrong.
Embrace any shocks or suprises, don't gloss over or bury them just because they don't agree with your view
Find a mentor or communicate with others involved in trading - seek out alternate views
4. Illusion of Control
This is the belief that somehow you can influence the outcome of events that you really have no control over. This is seen a lot among traders who actually believe that they can influence the outcome of a trade.
The reality is you are always at the mercy of the market and random events.
A classic everyday example of this is peoples belief that because they chose the numbers on their lottery ticket, it'll give them more of a chance of winning than one randomly generated by a lottery ticket dispenser. This is the illusion of control.
- Leads you to overestimate your own ability.
- Become too overoptimistic faced with a risky trade because you believe that you can control the outcome.
- Leads to overconfidence, over trading, taking too large a position, etc.
Guard against overconfidence. Don't think that just because you have accumulated a lot of information in regards to your trade that it will somehow affect the outcome of it.
Keep a trading journal and write down the decisions you make, why you made them and their outcomes and then review them from time to time.
5. Illusion of knowledge
The greatest enemy of knowledge is not ignorance, it’s the illusion of knowledge
This is one of those types of bias that along with the illusion of control leads directly to over-confidence.
Traders and investors alike often fall into the trap of thinking that the more information they can gather, the more control over their trading or investment outcomes they will have.
The problem is that this is a complete illusion.
This bias can be clearly seen by looking at just how many people lose money in the stock markets. They certainly don't go into the markets with this intention. In fact they are banking on the opposite and yet the majority still do.
Why? Well the fault is usually due to the illusion of knowledge. People tend to glean a little knowledge about the markets or maybe a particular stock or trading technique. They then apply that knowledge in a manner where they believe they know more that they actually do.
I know from my own experience that my worst trades have been the ones where I have researched and found out as much about the company I have bought into as possible.
Armed with this illusion of knowledge I then found it incredibly difficult to exit the stock when things started to go wrong. I believed I knew more than I actually did and of course told myself the chart action must be wrong.
Unfortunately the chart never lies and it cost me dearly in a couple of instances.
- Leads to the illusion of control
- May prevent you from acting on stops
- Can act to delay profit taking and stay in the trade too long
- Question the validity of your chart.
Seek out alternate views from other traders or a mentor, avoid the over confidence trap, be aware of your trading biases and the fact that a lot of knowledge doesn't mean you'll make a good decision.
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Faced with uncertain situations, representativeness bias causes people to look for familiar patterns and then assume that future patterns will continue in the same manner.
For example it doesn't mean that just because a chart looks bullish it'll continue higher.
This can be a big trap among traders trying to use chart patterns to determine future chart action. Often they blindly accept that a certain type of pattern will repeat, without looking into the reasons why the original pattern even occurred in the first place.
They may also fall prey to this bias by being attracted to buying stocks that have recently increased in price. This is what makes pump and dumps (where a stock is rapidly marked up to suck in investors and traders at higher prices) particularly dangerous for your trading account.
This is also commonly seen among fund managers who look at the returns from a given period of time and then expect them to continue at that same rate into the future. The true reality is that they have no real way of knowing if it will occur.
- A belief that events in the past will repeat again in the future. For traders this means believing a run will continue in a certain direction because it has in the past. Whereas the truth is it can change anytime.
A good knowledge and understanding of market structure. Look to larger time frames. Learn to see the big picture, accept that nothing is certain and have a plan to deal with that uncertainty.
7. Anchoring and Adjustment bias
Anchoring is focusing on one main piece of information when making a decision.
Many traders and investors will fixate on specific stock prices especially at levels where they have purchased stock previously or at what they deem to be the true value of the stock. This can lead them to think that the stock is undervalued, yet there may have been a change in the underlying fundamentals which they haven't seen.
The big trap with anchoring is that it prevents you from selling when you should and you will hang onto a losing trade because you are anchored to your original buy price.
This greatly increases your risk. Instead of acting on your stop loss and realizing a small loss. Now you are at risk of further falls in price as you wait for the stock to return to your original buy in price.
This is how traders and investors end up riding stocks all the way to the bottom and suffering massive losses.
- Hang onto losing trades
- Trade against the direction of the market
- Miss opportunities to get in a trade because of a pre-concieved notion of price.
Make sure you evaluate the data and determine if you are making an emotional decision or a data driven decision. Don't focus on only one piece of data, cross reference and get other peoples opinions.
8. Availability bias
This is a particularly interesting bias and explains a lot when it comes to people buying at market tops or into stocks at exactly the wrong time. This occurs because people tend to make decisions based on information they see most frequently.
This information of course may not necessarily be the most accurate, but it may be readily available. Hence the name.
An example of this and how it works is seen when stocks are rallying and hitting all time highs. A rational trader would see that things are becoming overbought and sit and wait for the inevitable correction.
Novice traders and investors bombarded with what they see on the news, hear on the radio or read on the internet develop a fear of missing out and may come to the conclusion that it is the time to buy.
They may do ok for a while, but as price invariable reverses and drops, they are usually still listening to the information in the media. This may be still telling people to buy and of course positions that should have been exited, are hung onto.
This is the kind of thing that occurs in every market downturn, people fail to see what is really happening. Of course by the time they do its usually too late, losses compound and psychologically it becomes impossible to exit and losses pile up.
Listening to and making trading decisions from information on blog posts, in forums, or from the media is inherently risky and feeds a lot of availability bias among traders. No wonder we see so many losing money.
- Failure to see what is really happening in the market
- Tendency to follow the herd
- Failure to see a turn coming or act on stops
- Develop a reliance on media or crowd driven information
Don't believe information gleaned from broker reports, the news, forums, tips from friends etc. Always do your own research and look at what the chart is telling you. It never lies!
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9. Loss aversion bias
Loss aversion bias refers to the tendency for people to dislike losing a lot more than they enjoy winning. It is seen when losses loom larger than gains of identical magnitude and people focus more on the potential loss.
This sounds pretty obvious but can have massive effects on your trading. Its a major reason why traders exit trades too early and don't manage to maximise their gains in winning trades.
In 1979 Kahneman & Tversky looked at many different types of bias and formulated what is known as the prospect theory. They found that losses are felt between two and two and a half times stronger than gains.
This then leads a lot of traders towards inaction rather than action, and they miss a lot of opportunities.
- Deviation from your trading plan
- Exit trades too early
- Keep stops too tight and get whipsawed
- Leads to the fear of taking a trade
Develop a sound trading plan before you take the trade and prepare to give your stock room to move. This means not setting stops too tight. Nothing ever goes up or down in a straight line in the markets.
Accept that you will only ever win at best 50% of the time and that losses are an inevitable part of the "cost of doing business". Don't hesitate to act once a buy signal occurs or a stop is broken, stick to your plan!
10. The Bandwagon or Herding bias
This I would have to say is one of the most important types of bias to be aware of. It is the belief that the general opinion is right. This leads to herd behavior in the markets.
Driven in part by the availability bias it is a MAJOR contributor to people losing a lot of money in the stock markets. In fact it is exploited by the smart money in a lot of cases to place the unwary into a position where they are either sold to or bought from.
As an example you may hear news in the media regarding a forthcoming market downturn but your chart isn't showing any signs of it.
You might then hop onto a stock market forum or maybe talk to fellow traders who confirm the bearish media view, so you decide to sell all your positions just to be safe.
The market of course then reverses, continues upward and leaves you behind.
Congratulations! You have just experienced a few different types of bias. The bandwagon bias fueled by an availability bias and you have now become one of the herd.
- Causes you to ignore your analysis
- Exit or buy at the wrong time.
- Encourages you to follow the crowd.
Learn not to follow the crowd, make you own decisions based on what you believe about your own analysis. Don't listen to and believe everything you see or hear on the news. If you have a mentor or forum group of like minded individuals get varying points of view.
Remember when the crowd is all moving in the same direction it means a change in direction is just around the corner.
As you have probably discovered by now, there are a lot of different types of bias and this is only a list of the 10 main ones, there are many more. We all suffer from bias in some form or another but being aware of their impact is the first step to controlling their effect.
In a lot of cases its probably not a great idea to try and rid yourself of your bias completely and frankly I'm not sure that's even possible. Trading without any confidence for example would be a very unprofitable outcome. You'd probably never take a trade again!
So there has to be a balance. In a lot of cases just being aware of all of these types of bias will help you. Keep a trading journal and make notes of your frame of mind when taking a trade or how you felt when you exited.
Review these notes from time to time and as you become more experienced, hone your trading system to accommodate and allow for these different types of bias.
Trade!...after all, nothing really teaches you more than being in the market!
Hopefully you have enjoyed this article. If you did and think it may be helpful to others then please share it. I'd also love to hear your views on this subject so leave me a comment below and let me know about what types of bias you think affect your trading and how you deal with them.