Understand behavioral science and psychology to boost your consistency and results!

Spencer Li

Optimism Bias – Why Most People Think They Can Beat the Market

Most people have heard of “rose-tinted glasses” and know that those who wear them tend to view the world with undue optimism. Studies have shown that with respect to most positive traits, for example driving ability, good looks, sense of humour, physique, etc, most people tend to rate themselves as above average. Logically speaking, this is not possible.

 

Optimism Bias

 

Traders, too, tend to be overly optimistic about the markets, the economy, the economy, and the potential for positive performance of the investments they make. Many overly optimistic traders believe that bad investments will not happen to them – those only afflict “others”. Such oversights can damage portfolios because people fail to mindfully acknowledge the potential for adverse consequences in the investment decisions they make.

Optimism can cause traders to think that they are getting above-market returns, when in fact they need to take into account things like inflation, commissions, and whether they would be better off simply buying an index fund.

Another danger is when traders read too much into rosy forecasts about the economy or a particular earnings forecast, which could cause them to take larger or more risky positions than they should due to “hope”.

What is the biggest danger of this bias?

There is yet another greater danger. Optimism bias can cause traders to think that they are above-average traders, simply because they are optimistic people in general, or to believe that they are above average in other areas of their life, such as driving ability or social skills, which could further lead to overconfidence bias.

“Comedy is acting out optimism.”

– Robin Williams

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Spencer Li

Conservatism Bias – Are You Afraid of Change?

Conservatism bias is a mental process in which people cling to their prior views or forecasts at the expense of acknowledging new information. For example, suppose a trader receives some bad news regarding a company’s earnings and that this news negatively contradicts another earnings estimate issued the previous month.

 

Conservatism Bias

 

Conservatism bias may cause the trader to under-react to the new information, maintaining impressions derived from the previous estimate rather than acting on the updated information.

It is important to note that the conservatism bias may appear to conflict with representativeness bias, but the latter refers to over-reacting to new information, while conservatism bias refers to under-reacting to new information.

The problem arises when traders cling to a particular view, behaving inflexibly when presented with new information which could signal a change in trend or underlying price action. Even when conservatism-biased traders do react, they do so more slowly, and will have increased difficulty in dealing with this new information.

What is the best solution for this?

The key here once again is adaptability and objectivity,  and when the wisest course of action becomes clear, it should be implemented resolutely and without hesitation. A good trader is continually assessing and re-assessing the situation, and not getting tied down to a particular viewpoint.

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Spencer Li

Self-Attribution Bias – Don’t Confuse Brains With a Bull Market!

Self- attribution bias (or self-serving attributional bias) refers to the tendency of individuals to ascribe their successes to innate aspects, such as talent or foresight, while more often blaming failures on outside influences, such as bad luck. There are actually two kinds of self-attribution bias, namely self-enhancing bias and self-protecting bias.

Self-enhancing bias represents people’s propensity to claim an irrational degree of credit for their successes, for example, if people intend to succeed, then outcomes in accordance with this intention will be perceived as the results of them acting to achieve the intention, regardless of whether the actions indeed played a crucial role.

 

Self-Attribution Bias

 

Self-protecting bias represents the corollary effect – the irrational denial of responsibility of failure, for example people trying to maintain their self-esteem by protecting themselves psychologically as they attempt to comprehend their failures.

Irrationally attributing successes and failures can impair traders in two ways. First, people who aren’t able to perceive the mistakes they’ve made are, consequently, unable to learn from those mistakes. Second, traders who disproportionately credit themselves when desirable outcomes do arise can become detrimentally overconfident in their own market savvy, leading to overconfidence bias.

When trades turn out well, people like to think that their method or analysis was fantastic, and that they are good traders. When trades do not turn out well, people will blame their broker, their platform, the news – basically anything but themselves. As you can see, over time, this leads traders to think that they are much better than they actually are.

What is the best solution for this?

One way to overcome this bias is to treat both winning and losing trades as objectively as possible, tabulating and recording them to obtain a running record. It also helps to do an objective post-trade analysis, reviewing your records to learn from past mistakes. With sufficient data, one can then objectively analyse the consistency of the methods and returns, and as they say – the numbers do not lie.

“Don’t confuse brains with a bull market.”

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Spencer Li

Representativeness Bias – The Dangers of a Small Sample Size

In order to derive meaning from life experiences, people have developed an innate propensity for classifying objects and thoughts. When they confront a new phenomenon that is inconsistent with any of their preconstructed classifications, they subject it to those classifications anyway, relying on a rough best-fit approximation.

 

Representativeness Bias

 

There are two main types of representativeness bias, namely (i) base-rate neglect and (ii) sample-size neglect. We will focus on the latter, since it occurs more frequently in trading.

In sample-size neglect, traders, when judging the likelihood of a particular trade outcome, often fail to accurately consider the sample size of the data from which they base their judgments. They incorrectly assume that small sample sizes are representative of populations. This is also known as “the law of small numbers”.

This problem is observed when traders try to backtest systems by using small sample sizes of data, and extrapolate their favourable results. However, these results are most likely not representative of the effectiveness of the system. This is a common tactic applied in marketing gimmicks.

Another common phenomenon has to do with hot tips. For example, you might hear someone say “my broker gave me three great stock picks over the past month, and each stock is up by over 10%”. While this is enough to sway most people, thinking that the broker is a genius, this assessment is based on a very small sample size.

What is the best solution for this?

If you want to evaluate the effectiveness of system or the stock-picking skills of a person, make sure you do it over a large sample size, and count both the hits and misses. This will give you a more complete representation of reality.

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Spencer Li

Cognitive Dissonance Bias – This Can’t Be True!

When newly acquired information conflicts with preexisting understandings, people often experience mental discomfort – a psychological phenomenon known as cognitive dissonance. Cognitions, in psychology, represents attitudes, emotions, beliefs, or values; and cognitive dissonance is a state of imbalance that occurs when contradictory cognitions intersect.

 

Cognitive Dissonance Bias

 

This term encompasses the response that arises as people struggle to harmonize cognitions and thereby relieve their mental discomfort. For example, a trader might take a long position in s stock thinking that the trend is up, however when a new cognition that favours a downtrend is introduced, representing an imbalance, cognitive dissonance then occurs in an attempt to relieve the discomfort with the notion that perhaps the trader did not make the right decision.

People will go to great lengths to convince themselves that the decision they made was the right one, to avoid the mental discomfort associated with their wrong decision.

Psychologists hence conclude that people often perform far-reaching rationalizations in order to synchronise their cognitions and maintain psychological stability. There are actually two kinds of cognitive dissonance bias – (i) selective perception, where people only register information that appears to affirm a chosen course, and (ii) selective decision making, where people rationalise actions in order to stick to an original course.

The dangers are obvious. Traders who are not bias-free cannot read the markets objectively, and will not be able to adapt fast enough to changing market conditions. Selective decision making could also lead to a resistance to cutting losses, and coming up with various excuses to avoid admitting their initial entry was indeed erroneous.

What is the best solution for this?

The key to overcoming this is to immediately admit that a faulty cognition has occurred, address feelings of unease and take appropriate rational action. If you think you have made a bad trading decision, analyse the decision; if the fears prove correct, confront the problem head-on and rectify the problem.

This above all: to thine own self be true,
And it must follow, as the day the night.
– Polonius to Laertes, in Shakespeare’s Hamlet

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