The human brain is a fascinating machine. It allows us to do many things simultaneously without having to think about doing them. You can drive a car, have a conversation about a complex topic on the phone, eating a sandwich, observing your daughter on the back seat, while all your inner organs and body mechanisms do their thing; this all happens effortlessly and humans wouldn’t be able to consciously control what is going on anyways.
This is only possible because our brain uses shortcuts to process data and information automatically. Unfortunately, those shortcuts don’t always work in our advantage and especially trading and investing require a different skill set and way of thinking.
The automation of thinking and making decisions is done through psychological biases or heuristics. We compiled a list of the 18 most common biases and heuristics and show how they influence trading decisions.
“This is the essence of intuitive heuristics: when faced with a difficult question, we often answer an easier one instead, usually without noticing the substitution.” – Kahnemann
What it means…
How it influences traders
|Availability||People estimate the likelihood of an event based on how easily it can be recalled.||Traders put too much emphasis on their most recent trades and let recent results interfere with their trading decisions.|
|Dilution effect||Irrelevant data weakens other more relevant data.||Using too many tools and trading concepts to analyze price could weaken the importance of the core decision drivers.|
|Gambler’s fallacy||People believe that probabilities have to even each other out in the short term.||Traders misinterpret randomness and believe that after three losing trades, a winning trade is more likely. The probabilities don’t change based on past results.|
|Anchoring||Overestimating the importance of the first available piece of information.||Upon entering a trade, people set their whole chart and analysis in reference to their entry price and don’t see the whole picture objectively anymore.|
|Insensitivity to sample size||Underestimating the variance for large and small sample sizes.||Traders too often make assumptions about the accuracy of their system based on just a few trades, or even change parameters after only a few losers.|
|Contagion heuristic||Avoiding contact with objects people see as “contaminated” by previous contact.||Traders avoid markets/instruments after having a large loss in that instrument, even when the loss was the fault of the trader.|
|Hindsight||We see things that have already occurred as more probable than they were before they took place.||Looking back on your trades and fishing for explanations why the trade has failed, even though those signals weren’t obvious at the time.|
|Hot-hand fallacy||After a success with a random event, another success is more likely.||Traders believe that once they are in a winning streak, things become easier and they can “feel” what the market is going to do next.|
|Peak–end rule||People judge an event based on how they felt at the peak of the event.||Traders look at a losing trade and only see how much they were in profit at the maximum, but don’t look at what went wrong afterwards.|
|Simulation heuristic||People feel more regret if they miss an event only by a little.||Price that missed your target only by a little bit or a trade where you got stopped out just by a few points can be more painful than other trades.|
|Social proof||If unsure what to do, people look for what other people did.||Traders too often ask for advice from other traders when they are not sure what to do – even when other traders have a completely different trading strategy.|
|Framing||People make decisions based on how it is presented; a gain is more valuable than a loss and a sure gain is more valuable than a probabilistic greater gain.||Traders close profitable trades too early because they value current profits more than a potentially larger profit in the future.|
|Sunk cost||We will invest in something just because we have already invested in it. before||Adding to losing trades because you are already invested, even though no objective reason to add exists.|
|Confirmation||Only looking for information that confirms your beliefs, ideas and actions.||Blanking out reasons and signals that don’t support your trade and just looking for confirmation.|
|Overconfidence||People have a higher confidence than what their level of skill actually suggests.||Traders misjudge their level of expertise and skill. Consistently losing traders don’t see that it’s their fault.|
|Selective perception||Forgetting those things that caused discomfort.||Traders forget easily that their own mistakes and wrong trading decisions caused their major losses.|
|Beneffectance||Feeling responsible for positive outcomes but not for inferable outcomes.||Traders blame the markets or unfair circumstances for their losses and take full responsibility for their winners.|