Behavioural biases play a big part in your trading. They affect how you enter and exit the market. Your trading performance will improve if you know what’s working against you so you can make more objective, rational decisions. Discover the ultimate list of cognitive biases in trading.
#1: Martingale Bias
Martingale theory relies on consistently doubling up on a bet when you lose – lose, double your bet; lose again, double your bet again. This is a super-high-risk approach. Think multiple flashing dashboard warning lights.
The theory has its roots with French gamblers in the 18th century. The premise here is that those who lose regularly can’t lose all the time – statistically it’s impossible. But no one has an infinite cash supply.
Your (considerable) foes are unpredictability and economic, regulatory and political risk. Risk a lot to win a little? Yes. Think Get Poor Quickly.
#2: Hot Hand Bias
This is the irrational view that consecutive winning or losing means your hand is ‘hot’ or ‘cold’. The thinking goes that because person X may have won several times in a row, they’ll win next time also.
This is a built-in dangerous cognitive bias and a misguided view of chance under most conditions (a so-called ‘winning streak' often precipitates disaster).
Generally, previous successful outcomes do not influence longer term performance. In investment terms a ‘hot hand’ is a very long distance from solid, fundamental valuations.
#3: Gambler Fallacy Bias
Also known as the Monte Carlo fallacy, this is the idea that odds will even out and can be exploited under normal conditions.
Think of a roulette ball. It may land consecutively several times on red. The gambler fallacy is based on the premise that – very soon – the roulette ball must land on black. Per se, a roulette has no memory.
And the spin of the ball has no connection with previous spins of a roulette wheel. Ever. History, then, goes in the bin.
#4: Clustering Bias
This cognitive bias is susceptible to seeing patterns where none may exist. Clustering bias relies on an expectation of probability or some illusion of control.
A clustering bias means it’s probable that to extend a winning streak you should keep to an existing strategy. It rejects, to a greater or lesser extent, variability or chance. It has some overlap with the gambler fallacy.
#5: Ambiguity Effect Bias
The ambiguity effect is when you prefer the known probability of something familiar over a second choice where the risk is less well known.
As far as investing goes, you might have a choice of solid government bonds where the interest rates are guaranteed in advance. Or, the chance to invest in shares where there’s less certainty – but a reasonable probability of a better return over time.
You possess known information about the bonds versus an absence of information about the stocks. Sometimes the ambiguous choice would produce a better return.
Do some fundamental analysis about your less-known option rather than just choosing the known option.
#6: Herd Instinct Bias
The psychological herding instinct is particularly apparent with trading and investing.
Media headlines in the business pages might talk of promising new markets or technology. Or the successful history of a fund manager (and the corresponding poor behaviour of another).
Often, this market ‘noise’ drives up prices to unsustainable levels. Billionaire investor Warren Buffett did not pile into IT stocks in the late 1990s’ disastrous tech bubble.
In other words, don’t get drawn in. Especially when fundamental values appear to be ignored.
#7: Disposition Bias
Boiled down, this is the fear of selling too early or too late. The disposition bias applies to multiple commodities, from shares to classic cars to property. At its core is the anxiety of possible losses.
For example, you buy into a stock that has appreciated sharply in value. The future fundamentals remain good – earnings, cashflow and debt levels. Yet you sell because, despite all evidence to the contrary, you fear the uptick can’t last.
It goes the other way: you refuse to sell a poorly performing stock because you prefer to wait for it to come back, even if the fundamentals don’t support a return to health.
This cognitive bias often includes large doses of pride resulting in – key here – illogical behaviour.
#8: Confirmation Bias
A confirmation bias is when you ignore or filter out anything that doesn’t square with your beliefs or prejudices. When you’re trading, this can be dangerous.
If you’re on the losing end of a trade, any news-related information supporting your existing position can be grabbed and clung to. Despite the facts. Or a larger truth.
A confirmation trading bias, then, means we ignore inconvenient information. One strategy to combat such bias is to actively seek out information that contradicts our own views – and listen hard to the reasoning and facts behind them.
#9: Recency Trading Bias
This is when you only focus on recent trading decisions, or the most recent outcomes, be they successful or not.
It means you’re abandoning logic and a solid trading strategy because you’re running on emotion. This myopia increases the likelihood of a future loss.
You can counter recency bias by approaching every trade as a fresh one and reminding yourself of your broader goals. That takes discipline.
Regularly recording your trades and results will remind you of the long-term foundations on which your trading system is built, and the effectiveness of your decision-making. In other words, keep to the plan.
#10: Hindsight Bias
You could call this cognitive bias a tendency to over-simplify. Hindsight bias, through the fog of memory, often means certain events loom larger in the mind than they did at the time.
That means it’s easy to ascribe cause-and-effect reasoning to it: that the event was completely predictable. The problem with ‘hindsight’ in trading is that it can lead to poor future reasoning. Or over-confidence.
However, the past never repeats itself. It is always difficult to predict the future. Hindsight bias has close links with confirmation bias.
#11: Anchoring Bias
An anchoring bias is when you may over-emphasise how much you pay for a trade. For example, you buy 10 shares for £10. The value of the shares promptly drops 20%.
But instead of absorbing the loss, you hang on for a hoped-for recovery because you haven’t got 100% of your money back, even though your trade may be close to your original ‘buy’ point.
This is a dangerous bias because your ‘anchor’ is utterly irrelevant to the rest of the market. Closely linked to the disposition bias.
#12: Attentional Bias
Here, we’re talking about paying attention. But not paying attention to all possibilities and options. So you may be focused on giving time to certain shares, asset classes or currencies but not others that may also be relevant – for any number of reasons.
Call it selective attention. It’s particularly applicable where different share classes or events look or feel familiar. Consequently, you make decisions at the expense of alternatives that might perform better.
This cognitive bias is often related closely to how you might feel emotionally at the time.
#13: Neglecting Probability Bias
This is another reasoning bias. Statistically, we know that travelling by train is safer than by car (in the UK, the Department of Transport can supply the fatality statistics to prove it).
But neglecting probability may ignore lower level, more mundane risk, such as a bad diet that undermines your health long term.
In trading, probability neglect might be a failure to assess a stock in a qualitative way – especially when there’s a significant degree of uncertainty – be it with careful modelling or other risk assessment possibilities.
Bottom line: neglecting probability bias skews your judgement.
#14: In-Group Bias
In-group bias often relies on a status quo or group-think that distorts reality beyond your peer group. This bias has any number of examples and can often mix up politics and money.
Think of the UK Brexit vote in 2016, which showed the media was out-of-touch with many voters (the referendum also led to a massive depreciation of sterling, weakening some people’s investments).
The point being that an in-group bias discriminates against other options. It can weaken your judgement about a wider reality, whether you’re trading or not.
#15: Post-Purchase Rationalisation Bias
This is about justifying a trade position or a consumer product you’ve saved for after you’ve bought it. Even if it turns out bad.
This cognitive bias means we may strongly remember aspects of the decision-making process (though these memories may be distorted) and our judgement about rejection possibilities at that time.
The memory of these past ‘rationalisations’ may play a part in our future decision-making – which may be ill advised. In other words, always be honest about why you bought a trade and learn from it.
Post-Purchase Rationalisation can also be called Choice-Supportive Bias.
#16: Survivorship Bias
Focusing only on those that have passed some form of test means you risk your investment choices repeating failures you had ignored. It distorts your wider field of choice. How might you discriminate effectively if poorly performing companies – which may have gone to the wall, for example – aren’t on your watch lists?
This bias can skew a broader investment valuation, particularly for mutual funds such as unit trusts that may own other companies from similar asset classes. Survivorship bias has strong links to selection bias.
#17: Selection Bias
This bias is dangerous because, at its worst, it can show some choices in a deceptively attractive light. That may mean deteriorating trading judgements if there’s a reliance, for example, on out-of-date or incomplete information.
The same goes for trading systems that may claim an advantage over others. For the vast majority of traders, there are few methods of trading or cognitive biases that outperform or supply an ‘edge’.
So, only trade on systems that are well known and robust and that absorb as many legitimate information channels as possible.
#18: Automation Bias
Typically, automation bias is when too much of a decision-making process is deferred to automated systems, often highly accurate. Over time these systems may be seen as infallible. Therein lies danger.
A particular problem with automation bias is that it can change how you approach a decision – following well-trodden paths of least resistance – and leading to fresh errors.
This bias has crept into many industries, particularly transport and healthcare. It’s increasingly widespread in trading and investing, lowering costs and improving liquidity. Automation advantages are many but the in-built bias, you’re warned, remains.
#19: Availability Cascade Bias
Availability cascade bias can be significant because it’s often personally felt or seen. It has strong roots to story-telling - you were there. This adds power and intensity to your trading decisions. The problem with this cognitive bias is that it can be difficult to push beyond it.
To check facts and properly validate. To get a longer view. Availability cascade bias can be offset by remembering that markets are cyclical and that buying on fundamentals – fair value, good management – keeps your decisions straight and clean.
#20: Blind Spot Bias
Essentially, your trading judgement tells you that other people’s judgement is biased – though you’re unable to recognise your own blind spots.
This lack of awareness can make it more difficult for you to take independent advice, or discriminate generally across your trading portfolio.
Even when you have a grip on your own biases, it doesn’t mean you are able to overcome them any better or worse than those who have more self-awareness.
#21: Home Trading Bias
Despite strong evidence that trading overseas can be profitable, you stick to home turf. Logically, most traders and investors know that investing in a wide range of global investments, currencies and asset classes provides strong diversification risk.
It’s also the chance to invest in low valued second-world economies as they develop long-term. Or to have extra protection against currency gusts and squalls, as well as a hedge against political risk.
But the urge to keep to the familiar is strong. Even for the very experienced.
#22: Endowment Effect Bias
This cognitive bias is when we place too much value on a trade or object we already own.
An endowment bias can mean you may be willing to pay more for shares, for example, if you already own shares from the same company. In contrast to buying shares from a company you haven’t bought into.
This bias has a strong relationship with ownership – you pay more to invest what you already own, compared with what you don’t own. Longer term this can reduce the potential value of your investments, even increasing risk levels.
#23: Attribute Substitution Bias
Think plausible short cut. This is when an inaccurate substitution or judgement is made. A trader might buy an asset without giving enough thought to its underlying volatility.
Or they study a complex asset class and make a quick, ill-judged decision about the long-term prospects because these prospects sound reasonable enough. Whatever the judgement, it’s likely to be wrong. Or inappropriate.