Cognitive biases are habitual ways of thinking that often significantly affect the way we make decisions. These habits can be hard to identify because they seem natural to the way we think. Perhaps they are, but they’re often fundamentally flawed.
When it comes to market speculation, cognitive biases can seriously mess up your decision-making process. Every little decision you make can make a huge difference in how things turn out. Traders are constantly bombarded with new information and changes in the market, which can trigger their emotions and sometimes lead them to make some pretty bad choices.
That’s why it’s super important to know which cognitive biases you might be falling prey to and to figure out ways to nip them in the bud. That’s what we’re going to do here in this article. While there are many cognitive biases traders face on a regular basis, here are (in our opinion) the five most dangerous ones to look out for. Most importantly, we’re also going to give you a few tips to conquer them.
1 – Confirmation Bias
Confirmation bias is a tendency to seek out information that confirms your preexisting beliefs while ignoring information that contradicts them.
What risks does it present?
It can cause you to overlook important information or evidence that might change your entire approach for a given trade. When you only seek out information that supports your preconceived notions, you’ll miss all the warning signs of risks or opportunities.
How you can prevent confirmation bias
- Seek out diverse information: Actively seek out information from a variety of sources that may confirm AND challenge your market beliefs and assumptions.
- Seek out opposing viewpoints: Seek out opposing viewpoints and opinions, and actively allow them to challenge your own beliefs.
- Be skeptical: You can benefit from a healthy dose of skepticism, critically evaluating the information you receive, regardless of whether it supports or goes against your existing beliefs and assumptions.
- Journal the rationale behind your trades: By keeping a record of your trades and the rationale behind them, you might be able to identify confirmation bias flaws in your thinking.
2 – Overconfidence Bias
The tendency to overestimate one’s abilities, knowledge, or the accuracy of one’s predictions, which can lead to taking on too much risk or making poor trading decisions.
What risks does it present?
The main risks you face with this bias is taking on excessive risk as a result of underestimating the market’s inherent risks. Traders who are overconfident often take positions that are too large, risking a huge portion of their capital and sustaining large losses when the market turns against them.
How you can prevent overconfidence bias
- Focus on risk management: Implementing a risk management strategy, such as setting stop-loss orders or using position sizing, can help prevent overconfidence bias by limiting your exposure to potential losses.
- Stick to your trading plan: Develop a trading plan that includes your entry and exit strategies, and stick to it. This can help you avoid making impulsive decisions based on your emotions or overconfidence.
- Seek feedback: Surround yourself with other traders and seek feedback on your trading decisions. This can help you gain a different perspective and avoid becoming too attached to your own ideas.
3 – Loss Aversion Bias
This bias occurs when traders are more strongly motivated to avoid losses than to achieve gains. Traders who are overly focused on avoiding losses may miss out on potential opportunities or make decisions based on fear rather than rational analysis.
What risks does it present?
Traders who suffer from loss-aversion bias tend to hold onto losing positions for too long, and exiting winning positions too early. Consequently, they miss opportunities to take profits or to avoid deep losses.
Loss aversion bias causes some traders to hold onto losing positions in the hopes that they will eventually turn around. This is usually a bad idea. At the same time, they may also be quicker to exit winning positions, fearing that they will lose their gains if they hold on.
How you can prevent loss-aversion bias
- Set a stop loss*: Set a predetermined level of acceptable loss for each trade and stick to it. This can help you avoid the temptation to hold onto a losing position in the hopes that it will turn around.
- Use proper position sizing: Determine your position size based on your risk tolerance and the potential reward of the trade. This can help you avoid taking on too much risk and potentially experiencing large losses.
- Focus on the big picture: Look at your overall portfolio and trading strategy instead of individual trades. This can help you see the importance of taking some losses in order to achieve long-term gains.
- Stay disciplined: Stick to your trading plan and don’t make emotional decisions based on short-term fluctuations in the market.
- Practice acceptance: Recognize that losses are a normal part of trading and accept them as a cost of doing business. This can help you avoid becoming too attached to individual trades and making irrational decisions based on a fear of losing.
4 – Anchoring Bias
This bias occurs when traders place too much weight on a single piece of information, such as the price at which they initially purchased a security. Traders who are anchored to a particular price may have difficulty adjusting their perceptions of the security’s value as market conditions change.
What risks does it present?
Anchoring bias can cause traders to fixate on a particular price point, asset, or market trend, leading them to overlook critical information and miss out on profitable opportunities. In short, they tend to miss every other important thing going on in the markets because they’re focusing too intensely on a single “thing,” which may or may not be important.
How you can prevent anchoring bias
- Consider multiple sources of information: Use a variety of sources to gather information about a security, such as fundamental analysis, technical analysis, and market trends. This can help you avoid becoming too focused on a single piece of information.
- Be flexible and open-minded: Avoid becoming too attached to your initial assumptions or expectations about security. Be willing to adjust your thinking based on new information.
- Think in terms of price ranges not price levels: Consider a range of prices when making decisions about buying or selling a security. Don’t rely solely on the price at which you purchased the security.
5 – Hindsight bias
This bias occurs when traders look back on past events and believe that they could have predicted them with ease. Hindsight bias can lead traders to be overconfident in their ability to predict future market outcomes and can make them less likely to learn from their mistakes.
What risks does it present?
Hindsight bias is when you think past events were more predictable than they actually were. This can lead you to overestimate your own forecasting abilities and make poor decisions based on past performance. Remember, if the future seemed indecipherable before the trade, chances are that hindsight (read: a “past” event) won’t help you decipher the future outcome of your next trade.
How you can prevent hindsight bias
- Think “preparation” and not “prediction”: As a trader, your job is to anticipate multiple potential outcomes and prepare for them. Your job isn’t to “predict” the outcome, because you can never know which outcome will eventually materialize. But, you can anticipate several possible outcomes and take advantage of whichever one comes to fruition. That’s why traders are called “speculators,” which is slightly different from the term “prognosticators.”
- Focus on the process, not just the outcome: Evaluate your decisions based on the information available at the time, rather than the outcome. This can help you avoid attributing success or failure to factors that were not under your control.
- Keep a trading journal: Write down your thoughts and decisions before, during, and after each trade. This can help you evaluate your decision-making process and avoid hindsight bias.
- Stay objective: Remain objective and avoid becoming emotionally attached to individual trades. Avoid making decisions based on hindsight bias or a belief that you knew what was going to happen.
- Learn from mistakes: Analyze your past mistakes and learn from them. This can help you avoid repeating the same mistakes in the future and improve your overall trading performance.
The Bottom Line
Cognitive biases can be hard to identify, yet they can significantly affect our decision-making process, especially when it comes to market speculation. Traders face various biases, and five of the most dangerous ones are: confirmation bias, overconfidence bias, loss aversion bias, anchoring bias, and hindsight bias. By being aware of and taking steps to prevent these biases, you can potentially improve your decision-making process.
Please be aware that the content of this blog is based upon the opinions and research of GFF Brokers and its staff and should not be treated as trade recommendations. There is a substantial risk of loss in trading futures, options and forex. Past performance is not necessarily indicative of future results.
*Be advised that there are instances in which stop losses may not trigger. In cases where the market is illiquid–either no buyers or no sellers–or in cases of electronic disruptions, stop losses can fail. And although stop losses can be considered a risk management (loss management) strategy, their function can never be completely guaranteed.