A simple negativity bias definition is a cognitive bias that occurs when a trader remembers and over-focuses on negative trading outcomes, allowing their emotions – such as fear and anxiety – to dictate their future decision making.
Negativity bias is part of behavioural finance studies, which examines how emotions and other external factors impact economic choices.
Below, we have negativity bias explained in detail.
Highlights
Negativity bias is a psychological phenomenon in which traders place more emphasis on negative information than on positive when making trading decisions.
It may occur due to a combination of various factors, including other cognitive biases, such as anchoring, loss aversion and confirmation, emotions, and the complexity of the decision-making process in trading.
It is important that traders are aware of their own biases and make sure they remain objective.
There are various techniques that may help potentially avoid or moderate negativity bias, including, among others, conducting data-driven analysis to limit emotion-driven decisions, implementing a systematic trading approach, and keeping a trading journal.
History of negativity bias
The concept of negativity bias dates back to the late 19th century, when it was first described by German philosopher Arthur Schopenhauer. Schopenhauer argued that humans are more likely to remember negative experiences than positive ones and suggested that this bias was a form of self-preservation.
In the 1970s, nobel-prize winning researchers Amos Tversky and Daniel Kahneman discovered that people tend to focus more on negative aspects, rather than positive during a decision-making process.
In the early 2000s, psychology professors Paul Rozin and Edward Royzman elaborated four elements of negativity bias:
Negative potency: Negative and positive events of the same magnitude are perceived unequally.
Negativity dominance: The whole is perceived as more negative than the sum of its parts, i.e. the combination of positive and negative events tend to be interpreted as more negative experience as a whole.
Steeper negative gradient: Negative events are perceived as more negative than positive events as more positive, the closer a person gets to a particular event.
Negative differentiation: Negativity is more complex than positivity. We have a richer vocabulary for describing negative conditions and emotions than positive ones. Negative events require mobilisation of more cognitive resources to minimise their consequences.
How does negativity bias work?
Negativity bias is a cognitive bias that causes people to pay more attention and give more weight to negative information than positive. When considering gaining and losing money, the risk of a loss usually trends to prevail strongest in one’s mind. Therefore, one would probably have a stronger negative reaction to losing $100 rather than positive feelings from gaining the same $100.
Negativity bias could have a significant impact on one’s trading outcomes. Affected by the bias, a trader tends to focus on negative experiences, news and events, such as stock market crashes and economic downturns, which could lead to poor decision-making based on fear rather than the facts. Moreover, a trader may be prone to panic, changing their decisions abruptly or simply failing to act by waiting for the situation to get better. This could lead to excessive caution and an unwillingness to take any risks at all or, conversely, excessive risk-taking.
Negativity bias may also lead to another psychological phenomenon – loss aversion, which refers to the tendency of people to value avoiding losses more than achieving gains. In trading, this may manifest as a trader being more willing to take small profits while being hesitant to cut their losses on a trade that is going against them. This could lead to holding onto losing positions for too long, resulting in larger losses.
Overall, making decisions based on emotion rather than objective analysis of market conditions could lead to irrational trading behaviour and significant financial losses.
Examples of negativity bias
To better understand the concept, let’s take a look at the example that demonstrates how negativity bias can affect a person in everyday situations.
Imagine an employee who works at a company that receives a lot of positive feedback from customers on a daily basis. However, one day, a single customer leaves a negative review, pointing out a flaw in the product or service.
Despite the numerous positive comments, the employee and his colleagues become fixated on this one negative review and give it more attention than it deserves.
In trading, negativity bias can take on several forms. Below are hypothetical situations that demonstrate how the bias can manifest itself in one’s decision-making:
In the past, a trader opened a long position on contracts for difference (CFDs) on Apple (AAPL) shares. Due to a number of factors, they experienced a loss. As a result, they become overly fixated on the loss they have incurred, leading them to make decisions based on fear and irrational assumptions rather than market trends and analysis. As such, even once the market conditions improve, the trader refuses to trade again.
A trader holds a long position on crude oil CFDs. One day, they wake up to news that nearly 100 tons of oil spilled into the waters of the North Sea due to a leak in the Royal Dutch Shell’s pipeline. The commodity’s price dips. Even though all indicators suggest the drop is temporary and the price will likely hike higher, the trader panics and decides to close their position on oil CFDs, incurring losses and missing out on potential profits.
A trader once used a swing strategy when trading CFDs on the S&P 500 Index (US500). Due to a number of factors, their position incurred losses. The trader formed a negative bias towards the particular strategy and now dismisses any evidence that suggests the strategy could be effective in a certain trading setting.
How to avoid negativity bias
Below are some points you may want to consider to combat your negativity bias. Note that you should conduct your own research beyond this article before making a trade.
Acknowledging it: Asking yourself questions that may reveal irrational behaviour and help recognise whether your decisions are emotionally driven. When deciding whether to buy, sell or hold an asset, thinking about whether you are giving enough consideration to all of the available information and possible options.
Staying informed, but don't obsess over the news: Keeping yourself updated with the latest market developments, but not letting negative news dominate your thinking.
Maintaining a balanced perspective: Trying to view both positive and negative news with an objective, balanced perspective. Avoiding getting too caught up in either extreme.
Keeping your emotions in check: Not letting a single negative event drive your trading decisions. Considering the broader context, trends and fundamentals, and the likely outcomes of different scenarios, while keeping your trading strategy in mind.
Using data-driven analysis: Referring to data and analysis rather than emotions or subjective judgments when evaluating market trends or making trading decisions.
Taking breaks: Giving yourself time to step away from the market and recharge. Taking breaks could help you maintain perspective and avoid getting overwhelmed by negative news or market movements.
Keeping a trading diary: A trading diary or journal could help you keep track of your decision-making process, as well as wins and losses to identify performance mistakes and analyse whether negativity bias has been at play.
Seeking professional support: Considering working with a trading coach or mentor who can help you identify and address negativity bias and other cognitive biases that may be impacting your trading decisions.
Essentially, one of the keys to overcoming negativity bias could be to try to be objective and flexible, and to be able to evaluate market conditions and make decisions impartially, regardless of what your current position is.
Conclusion
Negativity bias in investing and trading is the tendency to give more weight to negative information than positive when making a decision. This could often result in a trader making impulsive decisions based on fear or anxiety. For example, they may decide to hold onto losing positions for too long, or to exit profitable positions too early.
Negativity bias may be caused by a combination of other cognitive biases, emotions, and the complexity of the decision-making process in trading.
To combat this cognitive effect, traders could try to cultivate a more balanced perspective, engage in deliberate and systematic decision-making processes, and work to reframe negative experiences as challenges for learning and growth, among other tactics.
FAQs
What is an example of negativity bias?
One of the negativity bias examples could be a trader who holds onto a losing position for too long because they are overly focused on the negative news or market developments that led to the loss. The trader becomes fixated on the negative outcome and is reluctant to cut their losses, even when the market is clearly indicating that it is time to exit the trade. Such a behaviour could result in greater losses.
What is negativity bias in simple terms?
Negative bias is the tendency to focus on the negative aspects of something or someone, rather than the positives. In trading, the bias could cause a trader to hyper focus on bad outcomes rather than good ones, with their decision-making dictated by irrational emotions such as fear or anxiety rather than market trends and thorough analysis.
What is the opposite of negativity bias?
The opposite of negativity bias is positivity bias. Positivity bias is the tendency to focus on the positive aspects of something or someone, rather than the negatives. In trading, this type of bias could lead to over-optimism, with traders overlooking the risks associated with their trades.
How do you avoid negativity bias?
There are a few techniques that could help a trader combat negativity bias. These include, among others, cultivating a more balanced perspective, engaging in deliberate and systematic decision-making processes, and working to reframe negative experiences as challenges for learning and growth, among other tactics.
