Understand these 4 cognitive biases to get on top of your game
Updated: Mar 30, 2019
Traders sometimes forget that an essential part of becoming an elite trader is to have a firm psychology. It’s because we are actively trading and not long-term investing or gambling, we must work within a realm of probability. Being an active trader requires a full understanding of probability and a commitment to understanding the traps that will distort the reality of a probabilistic process.
In the course I not only divulge in the theory of cognitive bias and heuristics, but I also give practical knowledge to control your emotions. Ever felt nervous, scared, hopeful, greedy, rushed? These are traits of an unbalanced trader who, if they keep it up, will eventually lose.
Here, I am going to share with you 4 cognitive biases that will stop a trader from being consistently successful.
But firstly, what is a cognitive bias?
A cognitive bias is a systematic error in thinking which affects decision making and judgement. Sometimes it is related to memory or it can be related to attention; where limited access to information creates a selective view of the world. In short, our judgements and decision have errors, and these can come from our subconscious.
We tend to distort or block information because there is too much information. So, we only notice changes or repetition. This allows us to possibly see a pattern that may be evident in the short term but not necessarily present in the long-term. Additionally, to cut through overwhelming amount of information we tend to only notice stand out events or relate an event to our pre-existing belief.
For example, a trader makes an assessment that a trade is going to go against them… the trader remembers this from a few weeks ago or they saw the same thing happen when scrolling back through chart history… so they close the trade early, before it hit their profit target. This is a classic example of cutting a winner short due to confirmation bias.
We also tend to forget that there are vast amounts of information available to us and just focusing on one characteristic of trading like, just divergence or just Elliott wave may inhibit our ability to interpret the market from other points of view. This is called availability heuristic, a cognitive short-cutting process that considers recent events or immediate examples to form an opinion, topic, or method. It operates on the notion that if a person can recall something then it must be important or at least more so compared to alternatives.
Every time I go to the casino, I like to throw some chips around on Roulette. And, every time I snicker to myself when I see a young punter looking at the numbers board next to the table. This board shows a historical list of numbers with the most recent number on the top. The foolish gambler thinks that there is a relationship between the history and the possibility of future chances of numbers coming up. They also may look for patterns to try increase their probability. Of course, this is just a fallacy! Each spin of the wheel is completely independent of the other.
A trader may slide in to this trap by thinking that they must be less likely to get a loss after a string of losers. With this thinking they may increase their position size just to find out it is another loser. This is called Gambler’s Fallacy.
Loss Aversion heuristic is also a trader’s trap. If given a choice one will seek potential gain instead of accepting the risk even if both are considered balanced in outcome. This is called loss aversion; the rejection of potential loss and a weighting upon the more satisfying side of the outcome. We tend to focus on only two potential constituents of a trade; Loss & Gain.
Essentially the probability of gain is perceived to be likelier.
Individuals perceive gain or loss to generally be 50-50 regardless of the probability presented.
Losses cause a greater impact than equal gain and therefore an individual will always choose a choice of perceived gain.
The focus of a trade should be the outcome and not the gain or loss. I work through this in depth in the course when we unpack probability however when professionals trade, they will be confident in the outcome and be emotionless when trading.