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, eat a sandwich, observe 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 when it comes to trading and investing we require a different skillset and way of thinking.
The automation of thinking and making decisions is done through so-called psychological biases or heuristics. We compiled a list of the 17 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.|
After a loss, traders often get scared or try to get back to break even. Both mental states lead to bad trading quickly.
After a win, many traders get over-confident and trade loosely.
You must be aware of how you react to recent results and trade with a high level of awareness.
|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.|
I wrote about redundant signals and how to combine the right tools here: click here
|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.|
Even after 10 losses in a row, the next trade does not have a higher chance of being a winner.
|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.|
You must always have a plan BEFORE you enter a trade.
|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.|
A decent sample size is 30 – 50 trades. Do not alter anything about your approach before you have reached this number. And make sure that you follow the same rules to get an accurate picture of your trading within the sample size.
|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.|
Do not change your indicator or setting after a loss to come up with explanations or excuses. Accept that losses are normal and always follow your plan.
|Hot-hand fallacy||After a successful outcome on 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.|
I wrote about the hot-dand-fallacy in trading before: click here
|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.|
Do not change your reference point when in a trade and have a plan for your trade management and when to exit before entering a trade.
|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.|
The outcome is out of your control and you cannot influence the price movements. The only thing you can do is manage your trade within your rules.
|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.|
You must take responsibility for your actions and results. And not rely on someone else.
|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.|
Cutting winners too soon is a huge problem. If this is an issue for you, reducing screen time can be helpful. Do not watch your trades tick by tick.
|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.|
You must define your stop loss in advance and then execute it without hesitation when it has been reached.
|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.|
Especially when traders are in a loss, they only look for supportive information. Stay objective!
|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.|
Analyze your results objectively and get a trading journal to add even more accountability.
|Selective perception||Forgetting those things that caused discomfort.||Traders forget easily that their own mistakes and wrong trading decisions caused the majority of their losses.|
Do not blame the marjets, unfair circumnstances, your broker or any other outside event. You are the one who is responsible for making it work. It’s totally up to you and blaming others won’t help you make progress.
Which bias is the one that is causing you the greatest troubles? What are you workin on right now? Let me know in the comments below and I will answer with tips and ideas on how to overcome your struggles.