A psychological bias is like a mental shortcut or a pre-programmed response that our brain uses to help us make decisions faster. It's often based on our previous experiences, beliefs, and assumptions. Biases help us make sense of the world around us and respond quickly, especially when we have incomplete information, or when dealing with too much information to take everything in.
However, these biases aren't always accurate and can sometimes lead to errors in judgment. Most times, they can be quite helpful and save you time, but, when it comes to trading, they can lead to traders making costly mistakes.
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For example, traders often tend to continue adding to a losing trading position because of the time and/or money already invested. A trader might continue to hold a losing trade because they are unwilling to admit a mistake and take a loss, even if the outlook for the trade is objectively negative and violates their trading plan. We call this the Sunk Cost fallacy.
So, psychological biases are these innate tendencies that can influence our behavior, perception, and decision-making. They're not necessarily bad, but being aware of them can help us make better, more informed decisions – and this is not only true for trading but for all kinds of decision-making.
I want to go over the 5 most common and most problematic biases that are influencing decision-making in trading:
Hindsight Bias
This is the tendency for people to believe, after an event has occurred, that they could have predicted the outcome of the event – although in reality, they didn’t.
In trading, the hindsight bias often leads traders to change their trading systems and alter their trading rules after a recent loss or when they have missed a great trading opportunity. Traders will come up with completely new trading rules that would have allowed them to turn a realized loss into a potential winning trade based on the new information. Typically, this information has either not been available at the time of their initial trade entry, or would have required a completely different trading approach.
Changing trading rules based on just a single trade event is bad practice. Changing trading rules must be done based on a large enough data set (typically around 30 or more trades) and a change has to first be validated by a backtest.
Gambler's Fallacy
People tend to believe that past events can influence future outcomes in situations that are, in fact, completely random.
Here is an example:
When you flip a coin and heads come up 5 times, many people believe that tails is now overdue because heads has come up too many times. Of course, each coin flip is completely random and independent from the one before. Even after 10 heads in a row, tails is not more or less likely on the next flip.
In trading, traders believe that after 5 losses in a row, they are overdue for a winning trade. However, your next trade is independent of the one before, and realizing a winning trade does not suddenly have a higher (or lower) chance.
Loss Aversion Bias
This refers to the tendency for people to strongly prefer avoiding losses over acquiring gains. Some studies suggest that losses are twice as powerful, psychologically, as gains. Simply put, the pain of losing is psychologically about twice as powerful as the pleasure of winning.
This bias can lead traders to hold onto losing trades for too long in the hope that they will bounce back, or to exit winning trades too early to lock in gains, even though this goes completely against their trading rules and against any objective chart analysis. Their trading decisions are driven by emotions only.
Confirmation Bias
Confirmation bias refers to the tendency to favor, interpret, and remember information in a way that confirms our preexisting beliefs or hypotheses, while simultaneously ignoring or disregarding information that contradicts them.
When you are in a trade and let´s say your trading strategy gave you a buy signal for the EUR/USD and you are now in a long trade.
A few hours later, you come back to your charts to check your trade. The price action now does not look as bullish anymore and there are clear signs that your trade idea might not work out. However, because of the confirmation bias you may neglect the bearish signs and disproportionally focus on bullish signs, even though when it means using tools, indicators and concepts that you typically would not use in your trading strategy.
This bias can lead to poor trading decisions, as the trader is not accurately considering all available and potentially relevant information. They might hold onto the trade even when evidence suggests it would be smarter to exit, or they might buy even more when their signals warn against such action.
Ostrich Bias
Ostrich bias is when traders ignore negative information, similar to an ostrich burying its head in the sand.
In trading, this could mean that traders do not stick to their trading plan and do not act even though their trade is going against them, turning into a much larger loss, and they should have closed the trade long ago. Such traders also avoid looking at their broker balance just because they don’t want to face reality and hope that it will fix itself somehow.
Deviating from your tested trading rules is always a bad decision and will inevitably lead to inconsistencies and bad trading results.
It's important to make objective trading decisions even though they might not feel good in the moment.
Final words: Tips on reducing the impact of psychological biases
Psychological biases can impact decision-making in trading, lead to costly mistakes and damage your trading long-term. Overcoming these biases requires awareness and discipline.
Awareness allows traders to notice that their decision-making is impaired and not done objectively. To raise your level of awareness, keeping a trading journal such as Edgewonk.com will help you relive your trades and allows you to start noticing negative and destructive patterns in your trading behavior.
Discipline is needed to resist the urge to engage in negative patterns. Biases are hard-wired into the human decision-making apparatus and overcoming biases requires time and patience. It is important to realize that improving your approach to trading is a process. Don’t get discouraged when you fall back into old patterns from time to time.
Work on one aspect of your trading at a time, strive to make informed decisions by heightening your self-awareness, and continually refine your trading processes. Over time, with perseverance, you'll witness an improvement in your trading.
