How Cognitive Biases Can Affect Your Trading Performance
Cognitive Bias Definition
Cognitive biases, according to Wikipedia, is a ‘systematic pattern of deviation from norm or rationality in judgement … (where) an individual’s construction of reality, not the objective input, may dictate their behavior in the world’. Or in other words, sometimes the brain tries to simplify information to make it easier, and quicker, to make a decision. And it is this simplification, or reliance on a distilled version of reality, that can cause traders problems interpreting information in an objective fashion.
There is a wide range of biases that affect us in our daily life that can cause us to see patterns that are not necessarily there. Below is a list of six cognitive biases that traders should be aware of and know how to handle these pre-conceived thoughts.
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What are the Cognitive Biases?
- Confirmation bias.
- Anchoring bias.
- Self-serving bias.
- Optimism/pessimism bias.
- Availability bias.
- Risk aversion.
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Each bias is explained below with some pointers on how to avoid falling into one of the six categories.
1. Confirmation Bias
This is a type of bias where people look for information that confirms their original beliefs, and ‘bury their head in the sand’ when they are presented with information that does not agree with their view. For example, a trader believes that EUR/USD is going lower and will only take on board information and discussions that give credence to this view. Analysis and information that makes an objective argument that EUR/USD is going higher is dismissed, however informed it may be. Traders need to recognize when this is happening and keep an open mind to all views before making their mind up. Making a trading decision based only on one-side of a view that you want to hear, is dangerous and potentially costly.
2. Anchoring Bias
People sometimes adopt a long-term view of a situation based on the first piece of information they read on the subject, the ‘anchor’. For a trader, this can be very dangerous. If a trader reads a bullish article on gold or cryptocurrencies for example and anchors their views to this article, then they will always look at these asset classes through rose-tinted glasses, whatever the prevailing market is telling them. Traders should always remain open-minded and willing to change their view, however much discomfort it may cause them.
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3. Self-Serving Bias
In short, this is taking credit for when things go well but blaming other factors when things go wrong. This leads traders to look at themselves in an overly favorable fashion, as they believe all profits are due to their skills but all losses are due to the fault of others. Traders must be confident in their ability but they must also recognize when they have made a mistake, and work out why it happened and how to make sure it doesn’t happen again. Don’t let your ego have a negative impact on your P&L.
4. Optimism/Pessimism Bias
Two sides of the same coin - you’re either overly optimistic about your trade or your trading ability or you’re overly pessimistic. Traders who have an optimism bias tend to believe that they, or their trade, will do better than it does, while a negative optimism will likely mean that a trader misses a trade as the expected outcome is not up to their expectation. Trades should be looked at with a clear mind and no preconceived ideas, otherwise traders will not act rationally or with the correct level of risk management.
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5. Availability Bias
This bias is commonly described as the tendency to use information that comes readily to hand when making a decision. This can lead to bad decision-making as traders may base their view on easily available information instead of conducting thorough due diligence and fact-checking before entering a trade. In essence, individuals exhibiting an availability bias enter into trades on information that is often incomplete or even inaccurate. Careful consideration of fundamentals, technicals and risk management should be implemented in the decision making process.
6. Risk Aversion
This may not seem to be relevant to traders who, by nature of what they do, can understand and handle risk, but some traders may prefer to take on lower-risk/reward set-ups. Higher risk for higher reward - and vice-versa - is an important part of risk management and understanding but if a trader veers too far towards risk aversion, then trading can become low-risk/reward investing. Be comfortable with your own level of risk. DailyFX research has revealed that a prudent risk/reward approach factored highly among the traits if successful traders.
