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Got Two Trading Minds? Check Your Brain for Cognitive Biases

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November 21, 2017
Trader brain: Cognitive bias could be affecting your trading decisions
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Has this ever happened to you?

After doing your analysis, you find a handful of potential trade candidates. You check the fundamentals, the technicals, the charts, and narrow your choices down to one or two that fit your strategy. You select your entry point, plan an exit strategy, and set an alert to get you into the trade. But then when it triggers—for some reason—you pass, as if another part of your brain has overruled all the careful preparation and planning you’ve done.

If this sounds familiar, don’t worry; you’re not alone. As far back as the 1800s, cognitive psychologists have viewed the mind as having two parts, which often conflict in the decision-making process. This can lead to “thinking biases” that can affect traders. Let’s look at some of these biases and see what you can do to help moderate them.

Confirmation Bias: The Hand-Picked Proof in Your Pudding

Everybody likes to be right. Confirmation bias is the process of looking at information, but filtering out what doesn’t support a preconceived belief. Most of us know someone—a “perma-bear” who’s convinced a crash is always right around the corner, or a “perma-bull” who sees nothing but blue skies in the market, even when warning signs are present. With today’s 24-hour news cycle and ever-present social media, it’s easy to find enough data points to support whatever view you might have.

Recency Bias: Whatcha Done for Me Lately?

If you toss a quarter and it comes up heads three times in a row, recency bias says it’s more likely to come up tails on the fourth toss. “Coin tosses revert to the mean at 50/50, right?” you ask. Of course, it doesn’t work that way. Each flip is independent of previous flips. Recent data holds no more weight than any other piece of data.

But recency bias exists in the market. When the market is on an extended hot streak, expectations can become quite high, as if a bull run can go on forever. And many investors remember how, during the depths of the financial crisis, expectations were quite low. Why? Recent experience led many to believe the market would never recover.

Overconfidence: I’ve Got the Midas Touch

It’s okay to be confident, but sometimes it can distort your thinking, and that can cause problems. Overconfidence is at work when traders think their actions are responsible for their success, but they’re not. Case in point: a trader who begins trading in the middle of a bull market. They may see their success as a sign of their infallibility, when it fact it might be that the rising market is floating all boats.

Sunk Cost Fallacy: Throwing Good Money after Bad?

Have you ever started reading a book, only to find that after the first few chapters, you hate it? The sunk cost is the time you spent reading those chapters—time you can never get back, whether you stop reading the book now or continue to the end. In trading, it’s the money—and possibly time and energy—you may have already lost on a bad trade. The desire to try and get back that sunk cost may keep you from cutting the trade and moving on, or worse yet, cause you to double down on your position.

Spurious Correlation: The Price of Tea in China

According to data from the National Vital Statistics Report and the U.S. Department of Agriculture, the divorce rate in Maine is correlated with the per capita consumption of margarine. But correlation and causation are two different things. Nobody thinks eating more margarine causes divorce in Maine. But in trading we sometimes use a (spurious) correlation to justify our bias. For example: the last time ABCD stock went down, XYZ went up, so I’ll buy XYZ if ABCD goes down.

These are just a few of the thinking biases that our “two minds” can create for us. Others include:

  • Negativity bias: Only paying attention to bad news.
  • Bandwagon effect: Trading along with the crowd.
  • Saliency: Seeing obvious data and nothing else.
  • Status quo bias: Trading the same instrument repeatedly.
  • Representativeness: Seeing a pattern emerge and convincing ourselves it fits a trade setup.

Some of these biases stand on their own, while other overlap in their characteristics, but in all cases, they can potentially hamper your performance if you’re not aware of them.

Unifying the Two Minds

The underlying theme for all these biases is that they are subjective, which means they are fueled by emotion. They can also be quite subtle; many traders won’t even know when they’re being affected. But there is a two-pronged approach you can take to reduce their influence in your trading.

The antidote to subjectivity is objectivity. The more objective you can make your criteria for selecting, entering, and managing your trades, the more distance you’ll put between yourself and your emotions. And the less emotional you are about your trading, potentially the more disciplined you’ll be about following your objective criteria.

Once you have sidelined your emotions, the next step is to pay attention, or be mindful, of your process. This will allow you to recognize the signs and symptoms that might indicate you’re sliding back into one of those mental biases.

The mind is a tricky thing, and despite hundreds of years of psychology, we’re still a long way from mastering it. But by incorporating objectivity and mindfulness into your trading process, you’ll go a long way toward having the “two minds” think as one.

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