Psychological Biases in Trading & How to Avoid Them

Psychology is a big component of trading. The decisions we make are a product of the processing of the information that our brain takes in. This means that our psychological biases can have a big impact on our trading decisions.

There are many different psychological biases that can affect traders, but some of the more common ones are the gambler’s fallacy, confirmation bias, and loss aversion.

We’ll take a look at these fallacies and biases below.

Gambler’s Fallacy / Hot Hand Fallacy

The Gambler’s Fallacy is the mistaken belief that a particular outcome is more likely to occur because it has or has not happened recently, it is less likely to happen in the future.

This line of thinking is often referred to as the “hot hand fallacy”.

Gambler’s Fallacy Example

For example, let’s say you’re flipping a coin. The last five flips have all been heads.

You may be tempted to think that the next flip is more likely to be tails because heads have come up so often lately and things should balance out.

However, each flip of the coin is an independent event, and the probability of getting heads or tails is still 50% each time.

The Gambler’s Fallacy can lead people to make all sorts of bad decisions, like chasing their losses in gambling, because they think they’re due for a win and employing Martingale and other dangerous strategies.

Investors and traders can also fall prey to the Gambler’s Fallacy. For example, if stock prices have been falling for the past few days, some investors may think that it’s more likely that they will continue falling.

However, just because stock prices have fallen recently doesn’t mean that they are more likely to go down. Everything that is known is discounted into prices already.

When Is The Hot Hand More Likely to Be Correct?

There are cases where the hot hand is more of a gray area.

Baseball example

For example, let’s say a baseball player is batting .300 for the season (i.e., he successfully hits 3 out of 10 times he comes up to bat), but is 0-for-10 in his last 10 at-bats.

Is he “due” for a hit just because his performance has been so poor lately?

Just like flipping a coin, each at-bat in a baseball game is an independent event.

So it isn’t necessarily more or less likely a hit will happen on one at-bat versus another.

Obviously there are exceptions, such as being more likely to get a hit against a weaker pitcher relative to a strong one or being more likely to get a hit at home versus on the road.

So one could expect that there is a 70% chance that the 0-for-10 streak becomes 0-for-11 taking into account the overall body of performance.

However, there are cases where recent performance could be indicative of future performance.

For example, if the player is injured in some way that could reflect a new performance baseline until the injury gets better.

If a baseball player normally bats .300 and is 8-for-10 in his recent at-bats, does that mean he’s likely to perform worse to “even out” his batting average?

Or does it even mean his hot streak is likely to continue because he’s been hitting the ball so well?

There are cases where a player could genuinely be seeing the ball well, being in rhythm, and executing better. Or the competition could be weaker than normal over a short stretch.

Like many things in life, there is often a gray area and it may be hard to say with certainty whether the hot hand exists or not.

But in general, the Gambler’s Fallacy is still a fallacy because it assumes that past performance dictates future probabilities when, in fact, each event is independent in many scenarios.

The gambler’s fallacy is related to many other biases and fallacies as it pertains to behavioral economics.

 

Recency (Availability) Bias

The gambler’s fallacy is also related to the recency or availability bias.

This is the tendency for people to give more weight to recent information over older information when making decisions.

For example, if you’ve been on a winning streak in gambling, you might be more likely to think that you’re likely to continue to win because recent wins are still fresh in your mind. It might even be mistaken for skill.

You might be less likely to remember all of the times you’ve lost in the past because they happened further back and aren’t as salient.

Similarly, if you’ve had a string of bad luck recently, you may be more likely to think that it will continue because recent losses are still fresh in your mind.

This is why it’s important to be aware of biases when making decisions and to try to think objectively.

 

Anchoring Bias

The gambler’s fallacy is also related to anchoring bias.

Anchoring bias is the tendency for people to fixate on the first piece of information they hear (the “anchor”) and then make decisions based on that anchor, even if it’s not relevant.

For example, let’s say you’re asked to estimate the percentage of African countries in the United Nations.

If your first guess is 10%, you’re likely to anchor on that number and your second guess will be closer to 10% than if you hadn’t heard any number at all.

Similarly, in gambling, if you see that the person next to you just won a big jackpot, you may be more likely to think that it’s your turn to win because you’re anchoring on their recent success.

 

Overconfidence Bias

The gambler’s fallacy is also related to overconfidence bias.

Overconfidence bias is the tendency for people to overestimate their abilities and underestimate the likelihood of bad things happening.

For example, people often feel like they are better drivers than others, and that they are less likely to get into an accident.

However, the reality is that accidents happen all the time, and anyone can be involved in one.

Overconfidence bias can lead people to take unnecessary risks, and it can also make them less likely to prepare for worst-case scenarios.

For example, someone who is overconfident about their driving skills may not bother to get insurance, because they feel like they will never need it.

However, if they do get into an accident, they will be left with large bills that they might not be able to pay.

Overconfidence bias is a major problem in many areas of life, and it can have serious consequences.

People who are overconfident about their abilities often make poor decisions, and they may end up in situations that they cannot handle.

If you think you might be suffering from overconfidence bias, it is important to try to be more realistic about your abilities and the risks involved in various activities.

You should also make sure to prepare for worst-case scenarios, so that you will be able to cope if things do not go as planned.

Overconfidence bias is a big issue in trading.

When we are new to a subject, we don’t know what we don’t know. So it’s easy to be overconfident, which will inevitably lead to poor results.

This leads to our next phenomenon…

 

Dunning-Kruger Effect

The Dunning-Kruger effect is a cognitive bias in which people who are unskilled at something tend to overestimate their abilities.

This is because they lack the ability to see their own shortcomings, and so they believe that they are better than they actually are.

The Dunning-Kruger effect is related to overconfidence bias, but it is specifically about people who are unskilled.

People who are skilled at something tend to have a more accurate view of their abilities.

The Dunning-Kruger effect can lead to all sorts of problems, because unskilled people tend to make poor decisions.

They may take unnecessary risks or fail to prepare for worst-case scenarios.

Dunning-Kruger effect plotted on a graph

The Dunning-Kruger graph shows the phenomenon of high overconfidence in those who are only marginally aware of something or have low skill.

For example, someone with very low skill or knowledge may have high confidence in what they know even though they barely know anything. This is because they don’t even know enough to be aware of what they’re missing.

As people become more skilled, they become more aware of what they don’t know, so their overconfidence subsides. This is especially true for complex tasks, such as trading, playing chess, and similar pursuits.

And as time goes on and they become more skilled and experienced, they begin to have a better understanding of what they know and what they don’t know.

dunning-kruger effect
Dunning-Kruger Effect conceptually plotted on a graph; Source: Wikipedia

 

Dunning-Kruger effect in trading

In trading, the Dunning-Kruger effect can lead to big problems.

If you are new to trading, you may overestimate your abilities and take unnecessary risks.

You may also fail to prepare for worst-case scenarios, such as the impact of painful drawdowns, and so you could end up losing a lot of money.

It is important to be aware of the Dunning-Kruger effect, and to try to be realistic about your abilities when you are starting out in trading.

If you are unsure about something, it is always best to ask for help from someone who is more experienced.

Make sure they’re fully informed and have a good track record in what you’re trying to understand.

Moreover, don’t make the mistake of having a confident opinion in subjects where you are not strong.

 

Texas Sharpshooter Fallacy

The Texas sharpshooter fallacy is a cognitive bias that leads people to search for patterns in data, even when there are none.

This is because people tend to see patterns where they don’t exist, and they may ignore evidence that contradicts their beliefs.

The Texas sharpshooter fallacy can lead people to make all sorts of bad decisions, because they are basing their decisions on false information.

For example, someone who believes in the Texas sharpshooter fallacy may think that they have found a winning investment strategy, when in reality they have just been lucky.

If they continue to invest based on this false belief, they will eventually lose money.

The Texas sharpshooter fallacy is a big problem in trading.

Many people who are new to trading believe that they have found the perfect strategy, when in reality they have just been lucky.

If they continue to trade based on this false belief, they will eventually lose money.

It is important to be aware of the Texas sharpshooter fallacy, and to realize that there is no such thing as a perfect investment strategy.

There is always some risk involved in trading, and you need to be prepared for the possibility of losses.

 

Confirmation Bias

Confirmation bias is the most prevalent psychological bias in markets that is actually acknowledged by traders themselves.

This type of bias is when an individual only seeks out information that confirms their beliefs while ignoring any evidence to the contrary.

Confirmation bias is dangerous because it can lead people to make bad decisions.

For example, someone who is biased towards a particular stock may only look for information that confirms their beliefs about the stock, and they may ignore anything that contradicts their views.

This can lead them to buy the stock even when it is overvalued, and they may end up losing money.

It is important to be aware of confirmation bias, and to try to look at both sides of an issue before making a decision.

If you are considering investing in a particular stock or any instrument, make sure to do your research and consider all of the evidence before making a decision.

It’s important to not just look for information that confirms your beliefs, but also look for information that contradicts your beliefs.

Only by looking at both sides of an issue can you make an informed decision.

 

Cognitive vs. Emotional Investing Bias

Cognitive biases are errors in thinking that lead to bad decisions.

Emotional biases are emotions that lead to bad decisions.

Both cognitive and emotional biases can lead to big problems in trading.

For example, someone who is suffering from overconfidence bias may take unnecessary risks, because they believe that they are better at trading than they actually are.

Someone who is suffering from the Texas sharpshooter fallacy may think that they have found the perfect investment strategy, when in reality they have just been lucky.

It is important to be aware of both cognitive and emotional biases, and to try to avoid them when you are making investment decisions.

If you are feeling overly confident or you are seeing patterns where there are none, it is always best to step back and take a more objective look at the situation.

It is also important to get help from someone who is more experienced, if you are unsure about something.

 

How to Overcome Psychological Biases

Overcoming psychological biases is easier for some and harder for others.

Above all else, it’s important to be evidence-based.

All of our trading and investing decisions are based on data and information we take in and the processing of it.

Can you point to clear evidence supporting your decision?

Do you have a track record of success in the thing you are doing and have a clear understanding of the mechanics behind what you’re doing?

If you think you’re right, how do you know?

Have you sought out the thoughts and opinions of those who have knowledge on what you’re seeking to understand?

It can never hurt to hear another point of view. You’re just looking for the best answer, not simply the best answer you can come up with on your own.

It’s especially valuable when someone who is informed and credible disagrees with your view, as it represents the potential for learning if you can take in other information and view the evidence for and against each side.

Intellectually, people understand this by and large. But emotionally, it’s harder for some. They often view disagreement as conflict rather than an opportunity for learning.

In trading and investing, there will always be someone who disagrees with you. There is always someone on the other side of the trade.

You can never let emotions get in the way of making decisions.

It is also important to remember that no one has perfect knowledge, and that everyone makes mistakes.

Accepting that you will make mistakes, and that everyone else makes mistakes as well, and being able to learn from these mistakes is an important part of overcoming psychological biases.

And by doing so, we’ll be more likely to understand the importance of not being stuck in our own heads.

And to realize that, in markets, what you don’t know is always going to be greater than whatever it is that you know, and then understand how to manage this, such as having a balanced approach.

Trading Psychology: 10 Biases to Avoid

 

FAQs – Psychological Biases in Trading

What is the “hot hand”?

The gambler’s fallacy is the belief that if something happens often enough, it is bound to happen less often in the future.

For example, if a coin has been flipped 10 times and has landed on heads each time, someone who believes in the gambler’s fallacy might think that tails is due to come up on the next flip.

Of course, this isn’t true – each flip of the coin is a completely independent event, and the odds of flipping a head or a tail on a fair coin are always 50/50.

The hot hand is a related phenomenon, where people believe that if someone has had success in the past, they are more likely to have success in the future.

For example, a trader who has had a few winning trades in a row might think that they are on a “hot streak” and take on more risk than they should.

Both of these phenomena are examples of cognitive biases that can lead to bad decisions.

It is important to be aware of them, and to try to avoid them when you are making investment decisions.

What is the “Efficient Market Hypothesis”?

The efficient market hypothesis is the belief that all information is reflected in prices, and that it is impossible to beat the market, especially over the long-run.

This means that people who believe in the efficient market hypothesis think that it is impossible to find an investment that will outperform the overall market.

While the efficient market hypothesis is a popular theory, there is a lot of evidence that contradicts it.

For example, studies have shown that stocks with low price-to-earnings ratios tend to outperform the market over time.

This means that there are opportunities to beat the market, if you know where to look.

The efficient market hypothesis is a cognitive bias that can lead to bad decisions, because it leads people to believe that there is no point in trying to find investments that will outperform the market.

If you believe in the efficient market hypothesis, you may believe you can’t successfully add alpha to the markets over the long run.

 

Conclusion – Psychological Biases in Trading

Psychological biases can lead to big problems in trading.

The Gambler’s Fallacy, the Dunning-Kruger Effect, the Texas Sharpshooter Fallacy, and Confirmation Bias are all examples of cognitive biases that can lead to bad decisions.

Emotional biases, such as overconfidence bias, can also lead to big problems.

It is important to be aware of all of these biases, and to try to avoid them when you are making investment decisions.

The best way to avoid these biases is to get help from someone who is more experienced, if you are unsure about something. And always be improving.

The more you know, the more you can approach your job in an evidence-based way.

You should also take a step back and look at the situation objectively, if you feel like you are suffering from any of these biases.

Related

 

 

by