This is a Guest Post by Alex @MacroOps which was posted originally here: Avoiding Cognitive Biases In Trading it is reposted here with permission.
The following is part 2 of our 3-part psychology series. To read part 1, click here.
On top of rampant emotions and a dire need to “fit in”, our biological evolution also had another side-effect. It made us lazy.
Back in the day we were faced with an endless cycle of feast and famine. We’d have short periods of feeding followed by long periods of minimal sustenance living. So naturally we evolved to conserve our energy as much as possible.
If given two options we’re conditioned to choose the one that involves the least amount of effort. This applies not only to physical activities, but to mental functions as well. After all, the brain does account for up to 20% of the body’s total energy usage (more than any other organ). We’ll always go for the quick and easy solution over the tough one that requires more thinking. This is true even if the easy option ends up being wrong…
To help facilitate this low-effort decision making we’ve developed heuristics. Heuristics are simple, efficient rules we use to quickly make decisions and form judgments. They’re mental shortcuts that slice through complexity.
Yet even though these heuristics tend to work well most of the time, they can also lead to decisions devoid of rationality and logic. The resulting errors are what we call cognitive biases. Understanding these biases is important to help avoid them when making our trading decisions.
Recency Bias
Recency bias is believing what occurred in the recent past will continue to occur in the future.
Say you flip a coin and get heads five times in a row. Naturally you’ll begin to think the sixth flip will also be heads. Heads is the trend.
But in reality, you’d be wrong. This is called recency bias. You’re letting recent outcomes incorrectly influence your belief of future outcomes.
No matter the outcome of the previous trials, the probability of the next coin flip being heads will always be 50%. Believing anything else is illogical.
Investors consistently fall victim to this bias. It’s the main contributor to the complacency we see during each market cycle.
Consider the “buy the dip” mentality that plagued the post-QE era. One of the greatest financial crises in history occurred 8 years prior, and in the time in between investors trained themselves to throw risk management out the window and aggressively buy more each time the market fell.
It’s true that “buy the dip” worked well during that time, but there was no guarantee it would work in perpetuity. This is especially true considering the nature of market cycles. Strategies tend to work for a period of time until they don’t. And it’s usually the previously successful strategies that end up failing the hardest in the new environment. No one wants to be caught buying the dip when the market morphs from bull to bear. But unfortunately, recency bias leads a majority of investors straight off that cliff.
“Buy the dip worked before… so it must work again!”
Nope. Sorry.
Gambler’s Fallacy
On the other side of the coin (pun intended) we have the gambler’s fallacy (also known as the Monte Carlo fallacy).
This is the opposite of recency bias. It occurs when you start believing that because a certain result happened more frequently in the past, there’s a higher probability a different result will occur in the future.
Take the coin flip example again. Someone who flipped heads five times in a row may think the next flip has to be tails because of the 50% probability associated with the game.
This is once again illogical.
Over a large enough sample of trials (which can be performed through a Monte Carlo simulation), the number of heads and tails will be evenly split. But over any individual, shorter stretch, there is no requirement they must show up equally. You can have 100 head flips in a row and yet the probability of the next flip will still be 50% heads, 50% tails. The gambler’s fallacy is thinking the probability of a tails flip has increased based on the previous streak.
Our “buy the dip” example once again shows the dangers of this bias in markets.
The post-QE era was littered with the corpses of fund managers who tried to short the indices. Why’d they do it? It’s because they thought that after working so many times, “buy the dip” had to fail eventually.
“Business cycles only last 5-7 years. It’s due time for the market to correct for real and blow out all these “buy the dip” idiots.”
Again, this is not how it works. As John Maynard Keynes once said:
“The market can stay irrational longer than you can stay solvent.”
Sunk-Cost Fallacy / Loss-Aversion
A sunk-cost fallacy is continuing an endeavour due to previously invested resources (time, money, effort) even when the optimal decision is to stop.
Ever get full at dinner, but finish your plate anyway because you don’t want to waste the good money you paid for it? That’s the sunk-cost fallacy in action.
Loss-aversion is the tendency to strongly prefer avoiding losses to acquiring equivalent gains. The pain of losing greatly overwhelms the pleasure of gaining.
Marketers use loss-aversion all the time. Which of the following headlines make you want to buy more?
“Buy our insurance and save $100 a month!”
Or
“You’re losing $100 a month on insurance. Buy ours and save!”
The second one of course. The thought of losing $100 is much more powerful than the thought of just saving it.
Both loss-aversion and the sunk-cost fallacy make it difficult to cut losses in the market.
No one wants to cut a losing position after spending countless hours developing a thesis. It feels like a waste… all that work for nothing. It becomes easy to find yourself attached to an investment because of the sunk-cost fallacy.
But this mentality is completely irrational. Refusing to cut a loser, regardless of the initial time investment, leaves you exposed to an even larger total loss (time & capital) down the line.
Cutting a loss also becomes even harder when loss-aversion comes into play. Taking a loss not only means admitting you’re wrong, but also turns your paper loss into a real account drawdown. This is too much to handle for most, even if it’s in their best interest. The illogical fear of taking the pain now opens the door to even more pain in the future.
Confirmation Bias
Confirmation bias is seeking out information that supports an initial thesis while disregarding all else.
Rose-colored glasses are a large problem in the investment world. Too many investors find a company they like and then proceed to become its #1 cheerleader. They only look for news and press releases that support their positive image of that company. Any fundamental warning signs are immediately disregarded and objectivity is squashed.
This is asking to be unpleasantly surprised in the future. Confirmation bias creates a dangerous blind spot that has a high likelihood of decimating a trading account.
Observational Selection Bias
Similar to confirmation bias, observational selection bias involves noticing a particular idea and then falsely assuming that the frequency of available evidence supporting that idea has increased.
Say you develop a thesis that solar stocks should take off soon. And as soon as you create that thesis, you start to notice a huge increase in news stories and data that support it. This makes you even more confident in solar stocks.
This is most likely the bias in action.
Developing your initial solar thesis has you primed towards certain types of information. This priming is very easily confused with actual increasing sentiment towards the solar sector. Objectivity is once again smothered, making this bias crucial to avoid.
These cognitive biases are completely natural to have. And that’s what makes them dangerous. We need to stay vigilant of these biases to make sure they don’t creep into our analysis process. Objective analysis is the key to success in the markets. But for objective analysis to flourish, biases need to be squashed.
Stay tuned for the last article in our psychology series where we’ll discuss the solution to our faulty biological wiring. In the meantime, be sure to check out the Macro Ops Handbook where you can find out more about psychology in trading. Click here to access the Handbook.
For more posts and information about Alex follow him on twitter @MacroOps and you can check out his website Macro-Ops.com.