Know your biases
Trading psychology can affect your trading decisons and investment successes.
The perfect investor would make rational, smart decisions at the right time. Their past and their prejudices would disappear. They would act on logic based on carefully researched analysis.
They would also have sufficient tools – money namely – to make it work, not to mention a good buffer fund.
In reality all of us, to a greater or lesser extent, are governed by our emotions and ‘gut feelings’, not to mention our pockets. We can’t help ourselves.
But we can attempt to understand our in-built responses or biases so we can rein them in when we need to – though this takes effortful work.
Actions, outcomes and...shortcuts
When dealing with complex facts or we’re under pressure with time, our brains deploy short cuts. In behavioral psychology these are called representative heuristics. They’re useful when there’s an element, large or small, of uncertainty. The problem is, these shortcuts are prone to errors.
In the 1970s two Israeli psychologists, Daniel Kahneman and Amos Tversky, worked with the Israeli army to discover why so many Israeli tank drivers were being killed in action. Kahneman and Tversky’s work led them to look at decision making – and why gut feelings often turned out wrong.
It was the start of something called behavioural economics.
“They [Kahneman and Tversky] would learn to evaluate a decision not by its outcomes—whether it turned out to be right or wrong—but by the process that led to it,” said Michael Lewis in his book about the two men, The Undoing Project: A friendship That Changed Our Minds.
What the two Israelis figured out was the importance of working out the odds in any difficult situation and making sure they were cut down as much as possible.
Let’s look at two particular well-known cognitive biases that need careful handling.
Hot Hand Fallacy
Imagine you’re playing tennis (or any sport you like). Your game is good. You’re in the ‘zone’ where you’re serving up continuous strong shots. The crowd is with you. You’re unstoppable. You’ve…’hot hands’.
But many argue you don’t have hot hands. Tversky (and two other psychologists, Thomas Gilovich and Robert Vallone) wrote in a paper in 1985 that the pattern of a ‘winning streak’ was an illusion. Momentum was a fallacy. The players (and the crowd) were interpreting a pattern that was never there, they believed.