Cognitive Bias in Trading
What are Cognitive Biases? Cognitive Bias Definition
A cognitive bias is a systematic flaw in reasoning that can lead to making wrong decisions while investing. A common maxim in investing is that ‘you are your own worst enemy.’ Humans are naturally hard-wired to look for shortcuts and avoid complexities, but taking the easy road in investing can be very dangerous. Cognitive biases can interfere with rational and objective investing activity. They can influence your decision-making in the markets and lead you to make subjectively wrong investing decisions. It is, therefore, important to understand your personal bias so as to ensure you do not get in the way of your own success.
How Cognitive Biases Affect Trading
Investing is an activity that almost always boils down to making decisions. But humans already have their own existing belief system, which guides their overall decision-making. This is cognitive bias at work.
For instance, an investor may interpret new market information based on what they believe in, curve-fitting it to match what they expected. Investing is a highly psychological activity because of the emotional attachment humans have with money. It is, therefore, important to be aware of cognitive biases and learn how to control your innate human brain so that it does not work against you in the market.
Cognitive Biases List & Cognitive Bias Examples
Confirmation Bias Definition + Examples
When it comes to the confirmation bias definition, it is the natural human tendency to look for convenient information to support your beliefs or conclusions. It is also the tendency to avoid any inconvenient information. For instance, if you are bullish about a stock, you will seek opinions and articles that reinforce your bullish bias and conveniently avoid all other information that suggests the underlying stock may be in bearish mode.
This can be very dangerous in investing and can lead to clinging on to losing positions. It is, therefore, very important to take serious consideration of both positive and negative views when investing in any asset.
Hindsight Bias Definition + Examples
Hindsight bias is the tendency to believe that your past positive outcomes were a result of your ability to understand and predict what the market will do. It is also the belief that negative outcomes are the result of events that cannot be predicted. For instance, after a series of positive investing outcomes, an investor may come to a conclusion that ‘he knew it all along.’ This is a very dangerous mentality that can make an investor consider investing as a very simple activity. It can also make investors take unnecessary risks because they think they ‘know what the market will do.’
Recency bias is the tendency to give more weight to more recent information compared to much older information. The belief is that the current information can influence the future more than the older information, which is generally considered useless. For instance, if you hold a position on a particular stock, you can give more weight to a recent positive managerial change while conveniently ignoring that the company missed its earnings call by a big margin last quarter. When investing, it is important to carefully consider all available important information, whether new or old.
Availability heuristic bias is the tendency to make decisions depending on what comes to mind at any given time. Investors that suffer from this kind of bias make decisions based on what they can easily recall, such as recent memorable news, events, or even hype. For instance, if you recently watched the news about a stock that is trending, you will more likely buy it when you remember it while browsing through your trading platform. The danger of this is that personal trends or what comes to your mind at any given time are not actual market trends.
Also known as the Bandwagon effect, herd mentality bias is the tendency to copy or follow the ‘crowd’ at the expense of your own independent research and ideas. Investors who suffer from this bias gain comfort from holding positions that other investors also hold. This bias has been responsible for many price bubbles, which eventually get many investors burned. For instance, in 2021, there was a buzz around Dogecoin. Most investors flocked to it because of the ‘fear of missing out,’ but they were later trapped when prices tumbled significantly. When people are jumping onto an investment opportunity, it is difficult not to follow the ‘crowd,’ but that may often not be the best idea.
Anchoring bias is the tendency to apply more weight to a single piece of information when making important investment decisions. For instance, if you are looking to buy a stock that is trading at $10, you may focus more on the current price while ignoring other factors. This may be because you recall that the stock once traded above $30, which implies that the current price must be cheap. This may not be the case because you will not have considered other factors such as industry trends, economic conditions, and company management. When investing, it is important to consider as many factors as possible so as to arrive at the best decisions at all times.
Loss Aversion Bias
It is a natural human tendency to avoid losses. Investors who suffer from loss aversion bias are more eager to avoid losses than to pursue gains. This bias can work against investors because it clouds their sense of measuring opportunity cost. For instance, if you have bought into stock A, which is currently losing 50%, but you are unwilling to cut your losses to take a high probability opportunity in stock B. Investment is a game of risk and reward, and investors should be willing to accept losses from time to time, as much as they are always eager to obtain rewards.
The narrative fallacy is the tendency of investors to be attracted to investments that have ‘good stories’ while overlooking alternative investments considered to have rather ‘bad stories.’ In the stock market, there is a tendency to go for risky growth stocks while overlooking the value stock of well-established companies. For instance, an investor may be drawn to the stock of a company that wants to venture into trending areas such as cannabis and cryptocurrencies while overlooking stable stocks of historical firms that have a reliable track record.
Representativeness heuristic is the tendency to assume that closely related assets share a stronger and closer correlation than there actually is. For instance, a commodities investor may assume that the rise in Gold prices implies that Silver prices will also rise. Another example is a stock trader who may consider that the rising prices of one pharmaceutical company mean that another company in the same industry will also see its stock price appreciate. This may not always be the case, and there may be divergent directions, even on related assets.
Status Quo Bias
Status quo bias is the tendency to avoid taking decisions that may alter the current situation of an investment. It is an irrational desire to want things to stay the same. Investors that suffer from this bias avoid changing their minds even when presented with facts or information that say otherwise. For instance, an investor that believes stock A is in a long-term rally will consider price drops as just short-term ‘noise’ rather than an actual change in trend.
Blind Spot Bias
Blind spot bias is the tendency to recognize biases in other people’s views or opinions while failing to appreciate one’s own biases. Investors that suffer this kind of bias conveniently avoid seeing their own ‘blind spots.’ This is very dangerous because it makes such investors very resistant to independent opinions or views about a particular investment.
Overcoming Trading Biases
It is important to understand that, as human beings, we all have some form of unconscious bias. It is by this awareness that investors can start the journey to making consistently objective decisions in the market. Biases cannot be cured, but their effects can certainly be mitigated.
One of the best ways to go about this is by building a solid trading plan that details your strategy, risk management, and trading psychology. It is important to stick to it with strict discipline while also maintaining the flexibility to adjust it when new information comes, or market conditions change. Having a rule-based trading plan will guide you to make consistent investing decisions while avoiding the danger of subjective biases.
Many factors may influence the success of your investing activities, but one of the most important ones is to ‘think about your thinking.’ Understanding your biases and controlling their effects can provide you with the mental edge required to perform successful investing activities.
Open an AvaTrade account and practice your investing skills. Learn how to stay aware of your biases while trading on a demo or real account.
- International regulation in multiple jurisdictions globally
- Comprehensive education section to improve your investing knowledge and skills
- Favourable trading conditions, including low spreads, transparent prices, and fast trade execution
- Effective trading resources such as market analysis from Trading Central, AvaProtect, and AvaSocial
- Meet your trading preferences with hedging and short selling, which are allowed
Open a Demo account to practice what you’ve learned or a Real account to start trading today!