To succeed in the market long-term, you have to make sound trading decisions – decisions based on facts, not feelings. But these five financial cognitive biases can cloud your judgment. Learn to recognize and avoid these biases to keep your trading impartial, logical, and smart.
It’s human instinct to want to take credit for our successes, and to want to distance ourselves from responsibility for failures. In other words, we want to believe that all successful trades must be due to our brilliance, and all losses are because of something someone else did.
In reality, there are far too many other factors to take into consideration, and jumping to conclusions based on finger pointing or back patting will blind you to the reality of why a trade resulted in a gain or a loss, and how to replicate or avoid repeating the result.
To avoid falling victim to the attribution bias, carefully track and record every step along the way of each trade, and note why you made the decisions you made. Were you flying blind based on assumptions or gut feelings, or were you working with impartial facts and numbers?
The recency bias plays off a natural tendency to base decisions on emotions, and cruelly turns that tendency against you. It removes your ability to remain objective in your trading decisions by keeping you from looking beyond the results of your last few trades.
A few losses in a row will induce panic and despair, while a success or two will fill you with dangerous overconfidence that can lead to
recklessness. No matter what has been happening with your portfolio long-term, the recency bias will limit your focus and keep you from looking at overall trends.
The key to avoiding the recency bias is to be diligent in your portfolio and trade tracking. Before making any moves, step back and take a look at the long-term trends over an extended period, and leave the knee-jerk reactions and emotions out of your decisions.
Every day we are forced to make snap judgments and decisions in our lives. It’s how we are able to handle complex lives and busy schedules. But making a snap judgment about a trade based on a quick glance can be disastrous for your portfolio.
The diagnosis bias causes you to do just this. It leads you to make uneducated assumptions based on what you think you know, without taking the time to reconsider the facts.
Avoid the diagnosis bias by forcing yourself to take a subjective look at your trading decisions. Review all the information you have and trust the numbers and research, not your gut.
Selling for a gain can be thrilling – particularly for novice traders, but very few are immune from the high of success. After a big gain on a particular trade, it’s tempting to want to continue riding the horse that got you there. After all, if it isn’t broken, why fix it?
The problem with the addiction bias is that it can bring an obsession-like focus on a particular stock, with the memory of the big win preventing you from acknowledging any losses – even if they outweigh the gains – and keeping you from considering any other options that might be far better choices for your portfolio. In other words, you’re hooked and you can’t let go.
Kick the habit by charting every result, whether it’s a gain or a loss.
Force yourself to look at the numbers objectively, and realize that emotional attachment to a stock is damaging. You may want to set up limits for yourself, defining how much attention you can give to any stock before moving on.
If everyone else is doing it, it must be the right decision. After all, so many people couldn’t be wrong. Right? Not necessarily.
When you fall for the herding bias, you’re making a big – and risky – assumption that the rest of the herd knows what they’re doing and isn’t just joining the group because everyone else is. An incorrect conclusion by a tiny handful of traders or authorities, if they’re influential enough, can turn misinformation into gospel.
While following the crowd might seem like the safe and smart thing to do, don’t fall into the trap. Avoid the herding bias by taking the time to do your own research and then making decisions based on hard facts and figures.
Don’t allow financial cognitive biases to let your emotions take over your trading decisions. By keeping a clear head, remaining unbiased and using tools like TradeStops to give you the facts and information you need, you can make smarter, better trading decisions.
TradeSmith Research Team