Human behavior and psychology can have an impact on making trading decisions. You may not be aware of them but being aware of them can lessen the negative influences.
We love mirrors: They help us brush our teeth, perfect our dance moves, or remind us that our clothing choices are fantastic. But cognitive mirrors can go further. As reflections of past behavior and experience, they can help our brain decipher reality.
How often have you made what turned out to be a poor trading decision? Looking back, perhaps you can see that your actions were based on faulty or insufficient information, possibly previously held beliefs that led you astray. This phenomenon is called cognitive bias, and we’re often unaware of its potential to impact our trading decisions. So how can we mitigate negative influences?
Behavioral economist Daniel Kahneman detailed two systems of thought that shape general brain function. System 1 is fast, automatic, intuitive, and largely unconscious—it oversees things like pulling your hand out of a flame. System 2 is deliberate and analytic. Think balancing your checkbook or doing your taxes.
Both mental systems come into play when you trade. For example, if a trader sees a price anomaly like a flash crash, she may act on it because she sees an opportunity—or a significant risk. This is System 1. System 2 comes into play if the trader evaluates a complex option strategy with multiple legs, or takes a concentrated position with significant capital.
Hundreds of cognitive biases exist in both systems and can cause humans to act irrationally. They’re neither good nor bad. They simply exist.
Numbers can’t begin to capture the range of behaviors, emotions, and life experiences that drive human decisions. Although many traders rely on quantitative and qualitative analyses to help make trading decisions, certain cognitive biases can impact those investment decisions, and they don’t exist in isolation. They often interact.
• Confirmation bias: Traders may focus on information that confirms a preexisting belief even as they ignore objective data.
• Anchoring: Traders might jump to a conclusion based on the first piece of information received or their previously held beliefs.
• Overconfidence: Traders may have too much faith in their own analysis or ability, leading to higher-risk asset purchases or risky concentrated positions.
• Loss aversion: Traders may sell assets that have a gain, and retain assets with a loss (hoping the loss will reverse).
• Representativeness: Traders may assume that recent performance is an accurate indicator of future performance.
• Herding: Traders may follow the crowd.
• Emotional attachment: Traders may get emotionally tied to an investment.
To mitigate negative cognitive bias influences when you trade, study how they function. Try looking at your data differently. Here are a few steps you can take to help dilute those cognitive biases:
• Be aware. Biases exist. Identify and understand them. Analyze carefully.
• Be objective. Every trader needs to establish investment goals. What instruments should you buy or sell, and why? What’s your time horizon? Do you have the same or different goals for all security types or sectors?
• Be fluid. Research information from many sources and consider multiple perspectives.
• Be open. Talk to others with different opinions to help you challenge your own perceptions and conclusions. Engage in freewheeling discussions to generate new ideas.
Reflecting on your past trades and identifying what went wrong can be a powerful analytic tool for correcting future decisions. Yet being aware of cognitive biases can also help you stay in the present, keeping an eye on those subtle mental functions that could make or break your trades.