The last trade you took destroyed you. It’s game over. That, or just another string of losses accelerating your drive to financial ruin. Funny thing is that you can’t seem to explain what happened, no matter how obvious or simple it was. A dumb kind of simple. But you chose it nevertheless. It wasn’t the first time either. And you’ll probably do it again. As most traders do. “Win or lose, everybody gets what they want out of the market,” Ed Seykota once said. It’s just hard to come to grips with the notion that perhaps, deep down inside, you pursued your own demise. After all, the proof is in the pudding.. And your trading history betrays it all.
Haven’t we all felt this way? Poor trading performance is often due to one of three things: bad decision-making, bad execution, or a bad luck. We can’t do much about bad luck, but we can always try to improve our decisions and executions.
These are all surface-level processes; processes of which we are all aware. Beneath the substratum of conscious decision-making may be another issue altogether. Biases that in a trading context may prove destructive.
Here are five cognitive biases that you may want to consider:
ONE – The Bandwagon Effect
This goes by other phrases more commonly understood: safety in numbers, following the herd, etc. At any rather, this account for the historical pattern in which the largest decline during a bear market happens at the last one-third in which the investing public panics and sells en masse.
Institutions and smart investors are typically buying at this point. You know, “buy the fear.” Of course, this doesn’t necessarily indicate when you should buy, but one can argue that this bias may be attributable to the fact that retail investors almost always miss the boat, whether the market goes up or down.
Next time it happens, pay attention to see whether you missed it (…yet again).
TWO – Choice-Supportive Bias
You made a bad decision. And in the face of evidence (that you made a bad decision), you cherry-pick all of the “good” reasons why your decision may have been sound. Although this may apply to a wide range of varied scenarios, one particular scenario it applies to are traders who subscribe to a particular (and particularly “bad”) trading methodology or system.
It also applies to traders following most “trading gurus,” who (ironically) tend to blame their students’ poor performance on “bad trading psychology.”
Assess the bas underlying the methodology (or system). That means looking at all of the reasons why it might be questionable. You can’t be critical if you cherry-pick. Otherwise, you’re operating on faith. But a trading methodology is not a religion. You know this, of course. But you do it anyway!
THREE – Hindsight Bias
We all know this well. “I just knew it was trending up…it’s so obvious!” Or, “I had a feeling that the stock was going down.” No and no. You had no clue that the trend was up, and your feeling about the stock was, at best, 50/50.
You weren’t able to use your intuition to divine the future then, and you still can’t do it now. That’s why smarter traders operate on “principle,” where the possibility of bad outcomes are built into the strategy (remember risk management?) and not prediction.
Don’t let the present trick you into believing that you were actually able to predict the future. You know that doesn’t make sense. Strangely, this bias gets traders all of the time (go figure).
FOUR – Unit Bias
We all like “completeness” sometimes to a fault. You didn’t need all of those extra add-ons…but it came in a package. We didn’t need to eat all of the food…but we had to finish our plate. It shouldn’t have taken an entire three hours to finish the meeting…but we allotted three hours to fill. You didn’t need to load up on a complete position when the asset might have been (questionably) too overvalued…but you needed a “full position.”
That last part–loading up on a full position when the entry point is highly questionable–should be reconsidered. It marks the difference between “building a position,” and “doubling down” when the market goes against you: the former is about careful and calculated entry, the latter is about over-stressing your capital due to an impulsive transaction. Impulsive…that’s the key word here. You feel you have to complete a “unit” even when unnecessary. It’s like spending all of your cash in your wallet, simply because, well…itis in your wallet!
FIVE – Hyperbolic Discounting
And last but not least is the preference for a smaller reward now than a bigger reward later. Instant gratification, something we’re all guilty of. Perhaps it’s a reason why many traders choose to “trade” while not paying attention to safer and more longer-term investment options?
Or traders who are thrilled with each profit while not considering that all of their past losses are already far beyond what they can possibly make back in a lifetime, when not trading might have kept them more solvent and investing might have actually earned the kind of wealth that seems to perpetually elude them.
The risk of loss in the trading of stocks, options, futures, forex, foreign equities, and bonds can be substantial and is not suitable for all investors. Trading on margin or the use of leverage is not suitable for all investors and losses exceeding your initial deposit is possible. Supporting documentation is available upon request. Trading futures, options on futures, and FX involves substantial risk of loss and is not suitable for all investors. Carefully consider whether trading is suitable for you in light of your circumstances, knowledge, and financial resources and only risk capital should be used. Opinions, market data, and recommendations are subject to change at any time. The lower the margin used the higher the leverage and therefore increases your risk. Past performance is not necessarily indicative of future results.