Top Biases That Affect Traders

[Do Or Die 10]

People in standard finance are rational. People in behavioral finance are normal.

—Meir Statman

 

Behavioral finance tells us how biases affect individuals and patterns in crowd psychology. The foremost thing to learn from behavioral finance is what kind of biases effect you as a trader and how to avoid them. As mentioned previously, the book Behavioral Finance and Wealth Management by Michael Pompian does a good deal in articulating the biases.

 

When you begin to read about the description of biases, it may initially look academic and theoretical. Well, studying biases can go a long way further than telling yourself 'don't be too greedy, don't be too fearful'. Reminds me of another good book called 'Beyond Greed and Fear'.

 

Practically, the best way to control biases, is to understand which effect you in the first place. Again there is good amount of information on how to deal with bias but the most simple and effective way can be maintaining a Journal and writing the appropriate bias every time you make a mistake (Trading Journals- Some Information And Downloads). Over a period of time (say six months) you will have a good understanding of your weaknesses, and being aware of them is the first step in finding a solution to eliminate them.

 

The other important thing I would like to mention is that most of us tend to have a different research methodology, different trading style or different personality type. So there cannot be a generalization; each one has to learn about his weaknesses from the mirror (journal).

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Overconfidence

As the name suggested, it is the irrational faith in one's skills, methodology or beliefs. For example, you see a certain chart pattern and make a maximum leveraged trade, even though you understand that any chart pattern cannot predict market with certainty. Trading excessively after a winning streak also shows overconfidence.

 

Cognitive Dissonance

It means finding excuses for something which makes you 'uncomfortable'. For example, jumping from one indicator to another when you face losing trades; or continuing to trade in stock even your trading methodology does not gives you a positive expectancy.

 

Availability Bias

It means being biased to information which is readily and easily available. For example, people begin to trade using RSI without understanding the internal relative strength; that is, RSI is most talked about on forums so start using them without rationally researching it. Being affected from attractive advertisement or intelligent sounding articles (including this one!) without due diligence also signifies availability bias.

 

Self-Attribution Bias

It means giving yourself unwarranted praise for outcomes which may just be an outcome of chance. For example, people make money in a bull market through buy and hold and start begin to believe on their trading acumen rather than the market regime which favors their trading style.

Conservatism Bias

It makes people cling to a forecast or view- also results in herd behavior. It's not just about buying when everyone else is buying; a good example is using the indicators which are most talked about on internet.

 

Self-Control Bias

It means taking short-term decisions against what you understand rational and which conflict with your goal. For example, you finalize a watchlist of stocks and decide to stick with it. However, you may get tempted to trade a 'hot' stock.

 

Optimism Bias

It means painting a rosy picture for yourself even when common sense does not approves. For example, making 2K a month through full-time trading and congratulating yourself; or neglecting proper trading costs in your backtested strategies.

 

Confirmation Bias

It means to seek out only information that confirms their beliefs about a trade that they have made and to not seek out information that may contradict their beliefs. For example, marking only bullish chart patterns once you have bough a stock.

 

Loss Aversion Bias

It means trying to comfort yourself emotionally by not accepting your losses or mistakes. For example, widening your stop loss in losing trades or selling winners too early.

 

Recency Bias

It means giving undue weightage to recent information. For example, buying stocks because of sudden dip in gold or extrapolating a price pattern.

 

Regret Aversion Bias

It means undue avoiding of situations which can make you regret (being too conservative). For example, not trying unconventional trading strategies or stocking to a group of stocks for too long.

[Do Or Die 10]

Even so called 'system traders' may not be free from all bias. For example, most people who play around systems tend to refine/improve ideas and indicators which are already available on internet. Few go an extra mile to develop a system from scratch. This shows Availability Bias.