Lesson 2: Psychological Biases

Cognitive bias is best explained as a systematic error in thinking that affects decisions and judgments people make.

They occur as a result of our brains’ attempt to simplify information processing. In the financial markets, there is so much information to be processed.

Our brains use three primary methods to simplify information.

  1. Generalization – This is the process of generalizing information based on our perceptions. We use this strategy to map out our experiences. For example, If a light-skinned girl rejected me as a person, I could generalize that light-skinned girls don’t like me, or the approach I used was not good. Our unconscious beliefs primarily shape our generalizations.
  2. Deletion– Any time we form a belief, we usually filter out information that contradicts our beliefs. For example, if you believe pullbacks are dangerous in trading, it’s challenging to be objective and profitable if you are trading a bear market with deep pullbacks.
  3. Distortion– After generalizations, people settle on distortions to make information fit into their beliefs. Distortions happen at the sensory information level to help individuals map their experiences.

It is for these three reasons that beliefs are very important for success in trading and life. Beliefs ultimately shape our reality. We will look at this topic deeply in another lesson.

Biases often work as rules of thumb that help you make sense of the world and reach decisions with relative speed. We, therefore, need preferences to simplify decision-making.

Self-awareness over the biases we experience in trading can help us overcome these biases by recognizing when they are taking over our trading. We can also come up with trading rules which can help us trade better.

GAMBLER’S FALLACY

Trading is a game of probabilities. Every trade execution has a possibility of playing out based on the hit rate of our trading system. A trading system with a hit rate of 60% would mean that we at least have a 60% chance of being right in every position we execute. A string of wins or losses does not equate to a change in the hit rate, especially if it’s backtested.

Gamblers fallacy is best defined as the tendency to think that future probabilities are altered by past events when in reality, they are unchanged.

To understand this bias better, think of the casino. At no time will the casino ever doubt the probabilities of their success. A trader who suffers from the gambler’s fallacy is likely to take huge risks during winning periods and forget that the odds have not changed.

For example, imagine a trader trading a system with a reasonable hit rate of 70%. He executes multiple winning positions and confuses this with never having a losing position. He then decides to over position size in one trade, which turns out to be the loser. He ends up in a drawdown or a slump only because he didn’t understand the gambler’s fallacy.

If your system has a 50 or 60% chance of being right, one can “t be sure which trades are winners and losers at the point of execution. The biggest mistake you can make while trading markets is to rely on your previous performance while making decisions. Past performance is not a guarantee of future results.

OUTCOME BIAS

It can be explained as the tendency of traders to judge a decision by the outcome rather than based on the quality of the decision at the time it was made.

Markets are, by nature, random. Despite our edges in the markets, the distribution of wins or losses is random.

Traders often mistake only using the profit and loss statement to gauge how good they are performing in the markets. This is a mistake because you are likely to try and change your system or style of trading when you are in a slump or a drawdown period.

To illustrate the outcome bias, we can use the example of a trader who trades a system that mainly relies on Fibonacci pullbacks and extensions. The trader can execute a good trade on the 61.8% Fibonacci level, and the trade turns out looser.

Instead of viewing this as an ordinary loss in the market, a trader affected by the outcome bias will try and adjust his trading style only because he never focused on the process; instead, he was obsessed with the outcome.

To avoid the outcome bias, the trader needs to think of his trading as a package of multiple skills. It means as you do daily reviews of your trading, you should not only focus on the profit or loss statement; instead, you should be keen to answer the following questions and keep track of your trades:

  1. Did I follow my trading plan?
  2. Did I break any of my trading rules?
  3. Was my position sizing done in the right way?
  4. How well did I protect my capital by cutting losses quickly?
  5. Did I focus on profitability from individual trades rather than focus on profitability over a series of trade setups?
  6. Am I trading my system or personal trade setups?

These are good questions that would help turn your attention from individual trade’s performance and help you to instead focus on the process of trading that is important in the market.

CONFIRMATION BIAS

This can be explained as the tendency to search for, interpret, focus and remember information in a way that confirms one preconception.

People like to think of themselves as competent and intelligent. It’s for this reason that people want to marry their initial ideas or hypotheses. In the book Mindset, there are two general mindsets that most people adopt;

  1. Fixed mindsets
  2. Growth mindsets

The fixed mindset is the guy who knows it all and is not ready to change their minds and opinions. These kinds of people end up as consistent losers in the markets.

These are the traders who get married to their opinions and outlooks in the market. They are very poor at cutting losses which is one of the traits of successful traders. They are focused on being right rather than making money in the markets. Trading is all about making money. If you are in a losing position, getting out is the best solution.

The best traders have adopted a growth mindset; they seek to challenge their opinions, look for flaws in their thinking patterns, and constantly challenge their views about the market. Ray Dalio, a hedge fund titan, calls this stress testing your thinking.

To understand the difference between the two mindsets, we can look at examples in the markets. In 2001, we had the 911 incident, which resulted in market turmoil. Intelligent investors cut their losses early once they realize that they were wrong. The people affected by confirmation bias held their positions, looking for why the markets would come back soon. They ended up bankrupt.

As a trader, you should adopt a growth mindset. Any time a position is not working, don’t look for reasons why it will work. Instead, focus on reasons why the investment would fail.

Karl Popper, a scientist in the old days, said, “All progress in knowledge comes from disapproving our beliefs or ideas.”

ANCHORING BIAS

It can be defined as the tendency to rely on or anchor one trait or information when making decisions (usually the first piece acquired on that subject).

This bias commonly affects traders when markets are trending. For example, If I were to ask you where you think Amazon’s stock will be in three months, how would you approach it?

Many people would first say, “Okay, where’s the stock price today?” Then, based on where the stock is today, they will assume where it will be in three months. That’s a form of anchoring bias. We’re starting with a price today, and we’re building our sense of value based on that anchor instead of intrinsic value or fundamentals.

Anchoring bias can easily lead to “the call of the countertrend.” There’s a constellation of cognitive and emotional factors that makes people automatically countertrend in their approach. People want to buy cheap and sell dear; this by itself makes them countertrend. But the notion of cheapness or dearness must be anchored to something.

People tend to view the prices they’re used to as standard and prices removed from these levels as aberrant. This perspective leads people to trade counter to an emerging trend on the assumption that costs will eventually return to “normal.” Therein lies the path to disaster.

How to manage cognitive biases

  1. Self-Awareness – In dealing with many psychological problems, self-awareness remains one of the essential traits. Awareness of our patterns is the first step towards managing our cognitive biases.
  2. Using rules – We can come up with trading rules to help us regulate cognitive biases. For example, to avoid confirmation bias, we can ensure that we know where we shall exit the positions in the event of a loss or a win at the execution point.