How Cognitive Biases Can Impact Your Trading and Investment Decisions — and How to Reduce Their Effects In this article, we'll look at some of the cognitive biases traders and investors are prone to and what you need to do to limit them.
By Yvan Byeajee Edited by Chelsea Brown
Opinions expressed by Entrepreneur contributors are their own.
Are you a trader looking to improve your trading skills and increase your profits? Did you know that cognitive biases can have a significant impact on your trading decisions? Cognitive biases are inherent thinking errors that occur as humans process information, and they prevent us from accurately understanding reality, even when we are presented with the necessary data and evidence to form a more accurate view.
Let's see some of the cognitive biases traders and investors are prone to, and then I'll tell you what you need to do to limit them.
Negativity bias: This bias refers to the tendency to give more weight to negative information than positive information.
Loss aversion bias: This refers to the tendency for traders to prefer avoiding losses to acquiring equivalent gains. In other words, the pain of losing is psychologically about twice as powerful as the pleasure you get from profits. And this bias can cause traders to behave irrationally.
Gambler's fallacy: This bias refers to the belief that future events are affected by past events when, in fact, they are independent.
Confirmation bias: This bias refers to the tendency to seek out information that confirms preexisting beliefs and ignore information that contradicts them.
Hindsight bias: This bias refers to the tendency to believe that past events were more predictable than they actually were.
Anchoring bias: This bias refers to the tendency to rely too heavily on the first piece of information encountered when making decisions.
Bandwagon effect: This bias refers to the tendency to do or believe things because many other people do or believe the same.
Overconfidence bias: This bias refers to the tendency to overestimate one's abilities or the accuracy of one's beliefs and judgments.
Recency bias: This bias refers to the tendency to weigh recent events more heavily than earlier events.
Self-serving bias: This bias refers to the tendency to attribute positive events to one's own character or actions and negative events to external factors.
There are many more cognitive biases, but those are just some that are relevant in a field like trading. They come into the picture and structure the way we perceive market information, very often in ways that aren't helpful to our bottom line.
Related: How to Account for Cognitive Biases as an Entrepreneur
Why you can't completely eliminate biases
Cognitive biases are intrinsic to human thought and perception, and it's important to remember that just knowing about these biases doesn't necessarily free you from them. As a trader, your trading approach has to include mechanisms to limit such biases, or else you're just going to repeatedly shoot yourself in the foot — and you won't go anywhere in terms of consistency.
Once again, you cannot just rid yourself of biases. Some people appear to think you can, but to that, I'll say this: Not seeing your biases is itself a bias (blind spot bias — the tendency to recognize biases in others, while failing to see biases in ourselves)
Biases dumb down for us the complexity of the world — they're just how we see the world and think. They're inevitable. That being said, they can be mitigated. For instance, it is useful to remember that our brains have evolved these biases to deal with information overload.
The world is a complex place, and we're constantly bombarded with all kinds of information coming to our five senses. The best estimate I've read on this is that there is about 11 million bits per second worth of information available to our senses on a moment-to-moment basis. The research also tells us that our brain has a limited amount of information it can perceive at a conscious level, and that number is about 50 bits per second. That's a big difference, isn't it? 11 million are available, and only 50 get in ...
So, unsurprisingly what this means is that there is a huge amount of filtering going on in our brains, and that takes the form of habits in the way we perceive and think about things. We are constantly filtering information and selecting the ones that already fit our worldview.
And that's not all. Within that mess of information available to our senses, there's uncertainty. What do I mean by this? Well, there are many deep and important questions about reality that we don't know the answers to, and that lack of "knowing" and lack of certainty is confusing; it troubles us, so we fill in the gaps with our own stories and map it all to our existing mental models.
But some of the information we filter out is actually useful and important, so what does the mind do? Well, it fills in the gap with information it already knows, and sometimes this is good enough, but often it's not.
In order to act fast in a world fraught with all sorts of dangers, our brain needs to make split-second decisions that could impact our chances of survival. But quick decisions and reactions are often counter-productive because most of the time they're rooted in short-term emotional gratification. And short-term emotional gratifications often go against our long-term goals — what we know rationally is better for us.
Related: 13 Cognitive Biases That Really Screw Things Up For You
How to limit the effects of cognitive biases
Now, there are ways to limit the consequences of cognitive biases and improve your trading performance. The keyword here is "limit." Once again, biases are an inevitable part of human thought and perception, and we can only mitigate the extent to which they impact our results as traders.
You can use tools like meditation to become more aware of your inherent biases, thoughts and emotions. I'm really big on meditation, given my background as a meditation teacher, and I've found it to be very impactful in helping us develop self-awareness and emotional maturity. Living an examined life like that also helps us better accept that we are permanently biased creatures and that despite that, there's room for improvement. We can get better ... not be perfect, but better.
So, meditation is one way to limit the role of biases in your trading process. Another way is to adopt a rule-based approach to trading. "If X happens, I'll do Y;" "if Y happens, I'll do Z." You don't need to have hard rules for everything — just for the hard decisions where there's a lot of uncertainty and potential risk. Examples of hard decisions would be in terms of your position size, stop-loss placement and what you need to do in case of a gap below your stop-loss.
Soft rules will generally do for all the other lighter decisions, like your profit target or when to trade.
In conclusion, by understanding the ways in which cognitive biases can impact your trading decisions, you can develop effective strategies to mitigate their effects and improve your bottom line. Just keep in mind that our brains have evolved these biases to deal with information overload and the complexity of the world. But by coupling self-awareness with a rule-based approach to trading, you can make more informed decisions based on objective criteria and increase your chances of success in trading.
Related: Trading Psychology 101 — How Traders Can Manage Their Emotions and Achieve Success
