Your first reaction as you read the subject was thinking: “Yeah, but I’m not biased”

Of course, that’s what you would say!

The biggest problem with biases is that we never think we have any.

Biases are what everyone else has.

What are they and why are they important?

Biases are like shortcuts for your brain. They can have an unusually large impact on how you make decisions in your everyday life, but particularly when it comes to your trading.

To put it simply, your brain has a way of conserving energy by making fast decisions or mental shortcuts in what is known as ‘heuristics’.

The problem is, we often don’t even know that we have them. Even if we know about them, when it comes to trading, we must work hard to challenge our reasoning behind making our decisions.

As common as these biases are, we specifically want to focus on what is called “cognitive” and “emotional” biases.

Because these are so crucial to your trading, we’ve split this guide in two. This is part one.
Biases have been studied across psychology, economics and now into the mainstream of what is called “behavioural” finance. In fact, Richard Thaler, a notable behavioural economist recently won the Nobel prize for his work on the topic!

The sad part is that I know more about this topic because of my own mistakes in trading and so I try to be hyper-aware of rushing into trading decisions without considering the biases below.

The million-dollar question becomes, how many of these have you been a victim of and what can you do to try to prevent them yourself?
 
1)     Confirmation bias

This one is a doozy and for me, the most important of all of them.

If you take nothing else from today, it should be an awareness of confirmation bias.

Confirmation bias means we tend to seek out information only that we agree with.

Ask yourself this question: How many times have you placed a trade then sat there and watched it go against you? Sure, this happens almost every time, but then how often have you then gone out and sought information, headlines or “expert” advice about that currency pair which tells you why you were right and to just stick with it?

I remember many years ago, when I first started trading, I placed a fairly large trade on oil (don’t ask why I made this trade. I had no idea what I was doing and it was too big for my account... Forgive me, I was just a beginner!) but as soon as it went against me I frantically typed “Oil” into Google, and just like that I was looking for any reason to support my original opinion on why oil was due to go through the roof.

To my joy, there was some analyst from ABC Fund manager comforting me with a view that supported my own opinion or perspective. They talked about an undersupply in the market and that oil was sure to go higher. It was 2 am and I was sitting in my lounge room by this stage as I watched my whole account go into jeopardy. This valuable advice that I sought helped to nurse me back to sleep.

I, of course, deviously chose not to click on any article that might tell me I was wrong – I only sought out the information I wanted to hear or see.

Let’s just say that the oil trade I placed went as well as a parachute made of concrete! (Oh and my account was completely wiped out!).

How to overcome it: Stop, ask yourself a question – What information could you be missing about the rationale for this trade? What do the opposing arguments and research say?

2)    Recency bias aka availability heuristic

The “recency bias” or “recency effect” essentially tells us that our recent experience can become the baseline for what is going to happen in the future.

This might mean our recent trade performance such as a recent win or loss impacting us heavily. It might also mean a certain piece of news or information that we recently heard forming the basis for our decision making.

This can have seriously dangerous consequences for us as traders as it undermines our ability to form an objective decision on a trade. Why? Because of our lazy brain only recalling recent information. Whether that’s on our most recent trade or information we found as a barometer for how the next trade will go.

Let’s say you had a losing trade whereby you promised you’d never risk such a great amount of your capital again. You might be a little shy and dial back the risk a bit too much, or you could be the opposite and think you’re George Soros, betting the whole house on the next trade since you just went so poorly on the last. Your thinking is this would get you back to where you were prior to your last trade.

The other way it can creep into your trading is through recent information impacting your decision on why to take a new trade. It might be that you see a brief news headline stating ABC bank’s research on “why the dollar is going to dive this week” earlier in the day and tend to argue with yourself later that night why you think it’s a good idea to follow that trade. I know what you might be thinking: “It’s just a headline… I’d never let this happen to me”. However, our brain likes to take shortcuts to conserve energy. It will do its best to take what it knows and ignores the rest (as we have learned above).

We also have a tendency of the fear of missing out (FOMO as it’s popularly known today) and with this new information, we feel we must put something into action!

How to overcome the bias: As difficult as it may be, you must stop, count to three and ask yourself a few questions.

These could be “why am I making this trade?”, “Does it fit in with what I know?”, “What am I missing here?”, “Have I read something recently about this?”. Better yet, build yourself a checklist with these questions on it!

3)     The Endowment effect / Sunk cost fallacy

The endowment effect means we tend to value something more after we’ve owned it for a while.
In a now-classic study featuring Richard Thaler and Daniel Kahneman (both Nobel prize winners), students were given a mug and were asked how much they would sell it for an equally valued pen as an alternative. The experimenters found that the median price for which they would sell was TWICE as much as they were willing to pay to acquire the mug.

Because of our aversion to losses (also known as prospect theory – another big bias which I’ll cover later), this can have a drastic effect on our trading success. We place a trade on AUDUSD, with a target profit or loss of only 50 pips. Yet when the trade starts to go against us, what’s the first thing we often do? Move our stop loss further out because we “just know it’s going to turn around.” We tell ourselves stories like “The euro is cheap here, it’ll definitely turn around.”

Because we are committed to this trade (and this is somewhat related to the confirmation bias) we value it more just because we own it and because we have already invested in it, it becomes a “sunk cost”.

How to overcome: Fairly obvious advice to start; keep your stop losses and targets where they are. Be more mindful about why you’ve put them at these levels. If it helps you, write down the reasons why you’ve placed your stop and profit there and you can take comfort in understanding your own reasoning.

4) “The Gambler’s fallacy”

The gambler’s fallacy is where we believe that future probabilities are altered by previous events, when in fact, they’re unchanged.

It is called the “gamblers fallacy” due to the often-watched scene of any table game at the casino (e.g. roulette) as it continues landing on black over and over. People see this and think ‘it couldn’t possibly do that again’ and try to bet against it.

Being contrarian is great, don’t get me wrong.

However, as traders and human beings, we tend to believe that if something happens multiple times, it couldn’t happen again. We ignore simple probability.

Let’s say the S&P500 has rallied five days in a row. We place a trade in the belief that “it must be due for a correction” only to watch it rally and stop us out of our position.

How to overcome: It is important to look at the original thinking that led you to this trade. Just because something has moved up or down in a continuous fashion, it does not mean the market will immediately reverse its behaviour and go the other way. Just try catching a falling knife and you’ll know why.

5)     The Groupthink Bias

The “groupthink bias” is our inclination to do or believe things just because others do the same. Also known as the “bandwagon” or “herd behaviour”, it can lead to having a serious trading hangover; ask yourself an odd question like “why on earth did I go long the EURCHF last night?”

After all, you can’t do the same things others do and expect to win.

A recent example was after the US Presidential election. Everyone thought if The Donald got in, it would be a huge negative for the markets and the economy. Stocks fell initially and hard.

If you cashed out then and there because you thought it was going to lead to Armageddon, you made a very expensive mistake!

How to overcome: Sometimes it pays to be contrarian. If everyone is saying it’s going up, consider if going the same way will lead to riches. If everyone is saying it’s going down the toilet, consider if they could be wrong.

Be careful of those bandwagons!

So, which of the above are you most guilty of?