Understand behavioral science and psychology to boost your consistency

Trading Psychology | Regret Aversion Bias – Would You Rather Be Right, or Avoid Being Wrong?

People exhibiting regret aversion avoid taking decisive actions because they fear that, in hindsight, whatever course they select will prove less than optimal. Basically, this bias seeks to forestall the pain of regret associated with poor decision-making. It is a cognitive phenomenon that often arises in traders, causing them to hold onto losing positions for too long in order to avoid admitting errors and realizing losses.

 

Regret Aversion Bias - Would You Rather Be Right, or Avoid Being Wrong?

Regret Aversion Bias – Would You Rather Be Right, or Avoid Being Wrong?

 

Regret aversion also makes people unduly apprehensive about taking positions after a string of losses, as they feel instinctively driven to conserve, to retreat, and to lick their wounds. This might cause them to hesitate most at moments that actually merit aggressive behaviour.

This can also affect a person’s response to winning positions. For example, traders might be unwillingly to sell an in-the-money position despite negative signals, choosing to cling on to it because they fear that the stock might continue to soar even higher once they sell it.

People who are regret-averse try to avoid distress arising from two types of mistakes, (i) errors of commission and (ii) errors of omission. The former occurs when we take misguided actions, while the latter arises from misguided inaction, that is, opportunities overlooked or foregone.

The other danger comes from “herding behaviour” where traders simply try to follow the crowd, since following the mass consensus diffuses responsibility and hence the potential for future regret.

What is the best solution for this?

The way out of this is to have confidence in your methods and your skill, so that despite a string of losses, you will still be able to trade consistently, because you know that in the long run, you will be able to recoup those losses and turn up a profit when you manage to catch the big moves. The key here is discipline and consistency.

“I visualized my grief if the stock market went way up and I wasn’t in it – or if it went way down and I was completely in it. My intention was to minimize my future regret, so I split my retirement plan contributions 50/50 between bonds and equities.” – Harry Markowitz, father of Modern Portfolio Theory

 

Trading Psychology | Hindsight Bias – I Knew It All Along!

Described in simple terms, hindsight bias is the impulse that insists: “I knew it all along!” Once an event has elapsed, people afflicted with hindsight bias tend to perceive that the event was predictable – even if it wasn’t. This behaviour is precipitated by the fact that actual outcomes are more readily grasped by people’s minds than the infinite array of outcomes that could have but didn’t materialize.

Therefore, people tend to overestimate the accuracy of their own predictions. This is not to say, obviously, that people cannot make accurate predictions, merely that people may believe that they made an accurate prediction in hindsight.

 

Hindsight Bias – I Knew It All Along!

 

This affects future forecasting, because a person subject to hindsight bias assumes that the outcome he or she ultimately observes is, in fact, the only outcome that was ever possible. Thus, he or she underestimates the uncertainty preceding the event in question and underrates the outcomes that could have materialized but did not.

One detriment of hindsight bias is that it can prevent learning from mistakes. People with hindsight bias connected to another psychological bias, anchoring, find it difficult to reconstruct an unbiased state of mind, simply because it leads people to exaggerate the quality of their foresight.

When hindsight-biased traders have a winning trade, they tend to rewrite their own memories to portray the positive developments as if they were predictable. Over time, this rationale can inspire excessive risk-taking, because they believe they have superior predictive abilities.

Hindsight-biased traders also “rewrite history” when they fare poorly and block out recollections of prior, incorrect trades in order to alleviate embarrassment. This form of self-deception, in some ways similar to cognitive dissonance, prevents traders from learning from their mistakes.

What is the best solution for this?

In order to overcome hindsight bias, it is necessary, as with most biases, for the trader to understand and admit their susceptibility. One way to face the facts is to keep a trading journal, and use it to record your analysis and reasons for every trade, as well as the thought-process and emotional swings that went with the whole trade. This will be useful when you look back to the past after the event, and will prevent any disillusioned thinking.

“You didn’t know it all long; you just think you did.”

– James Montier

Trading Psychology | Loss Aversion Bias – Why a Loss Has Twice the Psychological Impact

Loss aversion bias was developed by Daniel Kahneman and Amos Tversky in 1979 as part of the original prospect theory. Basically, it suggests that psychologically, the possibility of a loss is on average twice as powerful a motivator as the possibility of making a gain of equal magnitude.

In short, it suggests that people woud prefer to avoid a loss to realizing a gain.

 

Loss Aversion Bias - Why a Loss Has Twice the Psychological Impact

Loss Aversion Bias – Why a Loss Has Twice the Psychological Impact

 

Loss aversion can prevent people from cutting losing trades, even when they see no prospect of a turnaround. Some industry veterans have coined a diagnosis of “get-even-itis” to describe this widespread affliction, whereby a person waits too long for a trade to rebound instead of cutting their losses. This is dangerous because the best response to a loss is to cut it fast and move on to a better trade.

Similarly, loss aversion bias can make traders dwell excessively on risk avoidance when evaluating possible gains, since dodging a loss is a more urgent concern than seeking a profit. When their trades start to show a profit, loss-averse traders hasten to lock in profits, fearing that, the market might reverse itself and rescind their profits.

The problem here is that exiting too early to protect gains severely limits upside potential. This prevents traders from catching the big moves.

What is the best solution for this?

This is where the importance of the stoploss comes in. If a trader is disciplined, and has a preset stoploss point, the trader will exit a losing trade once the stoploss point is breached. This removes any blind hope of a rebound, and by squaring off positions, it puts the trader in a neutral frame of mind to enter the next trade, and at the same time frees up the capital for it.

“Win as though you were used it to, lose as if you enjoyed it for a change.” – Ralph Waldo Emerson

Trading Psychology | Confirmation Bias – I See Only What I Want to See

Confirmation bias refers to a type of selective perception that emphasizes ideas that confirm our beliefs, while devaluing whatever contradicts our beliefs. This can be thought of as a form of selection bias in collecting evidence to support certain chosen beliefs.

For example, you may believe that more red cars drive by your house during the summer than during any other time of the year; however, this belief may be due to confirmation bias, which causes you to simply notice more red cars during summer, while overlooking them during other months. This tendency, over time, unjustifiably strengthens your belief regarding the summertime concentration of red cars.

 

Confirmation Bias – I See Only What I Want to See

 

To describe this phenomenon another way, we might say that confirmation bias refers to our all-too-natural ability to convince ourselves of whatever it is that we want to believe. We attach undue emphasis to events that corroborate the outcomes we desire and downplay whatever contrary evidence arises.

For traders, this is dangerous because traders who are entrenched in their opinion will only actively seek out information that confirms their opinion, while ignoring those that do not. This is especially true for traders who rely heavily on indicators, since many indicators will give conflicting signals, and it is not hard for a trader to find those indicators which support a chosen viewpoint.

Another hazard comes in the form of marketing gimmicks and market gurus, who like to make a lot of (absurd) forecasts based on their “sure-win” trading method or system. To newbie traders, they may appear to have a very high success rate, mostly because people want to believe the guru, hence they will celebrate his successful predictions while ignoring his less-accurate (or completely off) forecasts.

What is the best solution for this?

Once again, objectivity is necessary to see both sides of the coin, and the best way if you want to test if a method works is to record every signal (whether it is a gain or loss), and not just record those instances where it worked, while ignoring those times when it did not.

“It is the peculiar and perpetual error of the human understanding to be more moved and excited by affirmatives then by negatives.”

– Francis Bacon

Trading Psychology | Endowment Bias – Do You Really “Own” a Stock?

People who exhibit endowment bias value an asset more when they own it, as compared to when they don’t. This is inconsistent with standard economic theory, which asserts that a person’s willingness to pay for a good should always equal the person’s willingness to accept disposition of the good.

 

Endowment Bias - Do You Really "Own" a Stock?

Endowment Bias – Do You Really “Own” a Stock?

 

In essence, this bias is a mental process in which a differential weight is placed on the value of an object. That value depends on whether one possesses the object and is faced with its loss or whether one does not possess the object and has the potential to gain it.

If one loses an object that is part of one’s endowment (ownership), then the magnitude of this loss is perceived to be greater than the magnitude of the corresponding gain if the object is newly added to one’s endowment.

For example, this bias influences traders to hold onto losing positions because they feel that they “own” the stock, and are reluctant to sell them and buy a better stock instead, although the potential gains are higher. This is often the result of decision paralysis, which places an irrational premium on the compensation price demanded in exchange for the disposal of the endowed asset.

What is the best solution for this?

One way to break free from flawed thinking is to ask yourself, “if you did not have any positions at the moment, would you still choose to buy the same stock which you are currently holding?” If you answered no, then you might want to reflect on why you are still holding onto it.

“A wise man should have money in his head, but not his heart.”

– Jonathan Swift