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.
How might this affect your trading?
- A belief in ‘hot hands’ could lead to increased over-confidence and bad decision making
- It flips the other way: when traders believe their chances of success are down they may stop trading and miss opportunities they normally would have comfortably exploited
- Their losses could accelerate quickly as they try to re-claw their original position
Reversing these cognitive gymnastics we have…
This bias argues that whatever losing streak you may be on, at some point your luck will change. It has to change: the law of probability dictates it.
Say you toss a coin five times. On every toss the coin lands on tails. If you believe in Gambler’s Fallacy you think the probability of the sixth toss landing on heads must be higher on the next coin flip.
Wrong. That’s because every coin toss is always a new event. The coin has no memory of what came before. Ever.
How might this affect your trading?
- In the investing and trading world this might mean you pull out of a trade because you don’t believe a position can continue its bull run
- …but without any extra insight or fundamental analysis of the situation, why not?
- Sadly, the Gambler’s Fallacy ferments more gambling or risk when people lose and casinos everywhere reap the rewards
In order to avoid both the above fallacies, you’re advised to base your judgement on independent research or basic technical analysis - and nothing else.
Process, rules and a plan
The trading world is full of distractions. Not just about potential losses but also profits: what do you do when you’re successful with a trade? Do you sink it into more trading? Or do you stash it away?
So you need to be focused on your strategy – i.e. protecting your losses – and your mental state: making sure you’re in the right frame of mind to trade in the first place.
It’s also important to understand that most people take comfort from putting faith in patterns when there are none. None whatsoever.
So take the long view and know that trading losses are perfectly normal and probable, as are profits. The trick is making more profits than losses.
- Trading success or failure is not just about skill or experience. It’s often about random events and managing your fear or anxiety levels to deal with those situations
- None of us are truly objective but being more aware of our in-built biases will help you be a better trader
- Familiarity with markets and how they work is always better than another opinion