In the last chapter, we introduced the concept of trading biases and spoke about confirmation bias, self-attribution bias, anchoring, and gambler’s fallacy. In this chapter, we will speak about some of the other common biases that traders face when trading.
You can think of recency bias as something that is on the other extreme of anchoring bias. Sometimes, there is a tendency for traders to give a greater importance to the more recent trades or events rather than looking at the overall picture. Let us understand this using an example. Let us assume that of the past 100 trades that a trader took, 70 were profitable. However, of his last 10 trades, he was profitable only 3 times. Despite 70 of his past 100 trades being successful, the trader got nervous when executing the next trade and decided to lower the position sizing. Why? Simply because his memory is attached to his most recent 10 trades, which have been poor. Notice here how the trader is letting his most recent trades affect his decision-making ability, despite having achieved a great success when looked at from a bigger picture. Here, the trader has exhibited recency bias.
Recency bias can be exhibited even in case of security prices and trends. For instance, let us assume that a medium-term trader is currently holding a long position in one stock. He is bullish on the stock prospects and expects it to continue rising in the next 2-3 months. However, in the last 4-5 sessions, because of a correction in the stock market, the stock has declined. Despite being bullish on the stock, the trader decides to cut his position. Here, see that his trading decision has been influenced by the recent events, despite the broader picture still looking positive. In short, he has exhibited recency bias.
Recency bias can cause a trader to lose discipline and take decisions emotionally. For instance, in the above case, notice that because of a string of losses among 10 of his most recent trades, the trader decided to reduce the position sizing on the next trade, despite having achieved a greater success over the past 100 trades. Similarly, if all of the past 5 trades have been profitable, a trader could take excess risk on the next trade despite having a sub-par success rate over the last, say, 50 trades.
How to overcome recency bias?
Recency bias cannot be completely eliminated as there is a natural tendency for humans to be affected by the most recent developments. However, steps can be taken to ensure that the decisions you take are not influenced by them. When it comes to trading performance, one way to overcome recency bias is to ignore the near-term performance and focus on the longer-term picture. For this, it is necessary to maintain a written record all your trades, as doing so would enable you to easily monitor your performance across periods, including the long-term. On the other hand, without a written record of all your trades, you will forget your overall performance and be inclined to focus only on the near-term performance, because it is easier for our minds to retain recent information than the ones that have occurred in the distant past. Stay neutral and do not allow euphoria or scepticism based on recent events to cause you to deviate from your trading plan. Always keep the longer-term picture on the back of your mind and ensure that you stay disciplined throughout rather than take decisions emotionally.
Once an event has occurred, there is a tendency for us to look back at that event and conclude: I knew that this event would occur, and I knew its outcome. However, the fact is, prior to that event occurring, no one could predict with certainty its occurrence and its potential impact. If they could, they would have acted to benefit from it. This tendency of people to look back at history and overestimate their skill in predicting an event and its outcome, which is otherwise not possible to be predicted beforehand, is called hindsight bias. Let us understand this from the context of the stock market. Back in March-April 2020, markets were in a freefall and the sentiment, in general, was one of pessimism. Fast forward to today, not only have the markets recovered significantly from those lows but are in a powerful bull run. Looking back at the developments of the past 15 months, one might conclude: I knew that this rally was incoming and that the markets would double in the coming months.
Hindsight bias is quite common in trading. For instance, when a trade goes wrong, a trader could look back at say: I knew this would go wrong, wish I had not taken it. Even when a trade has gone right and the trader has exited at a profit, he could look back and say: I knew that the stock would gain more, wish I had held on to it. The problem is that it is easy to look back at what has happened in the past and say, I wish I had acted this way, I wish I had traded that way, I which I had bought the stock at the bottom and sold at the top etc. It is quite natural to feel so. However, if you frequently start thinking this way, it can start affecting your mind and cause you to take decisions emotionally. Furthermore, hindsight bias could act as a barrier to learning from past mistakes and could breed overconfidence in your ability to predict future events. All of this could cause you to deviate from your trading plan and risk management strategies.
How to overcome hindsight bias?
When you look back at your past trades, only do so from the point of view of learning from those trades. Never look back at your past trades and conclude you knew it all along, as doing so could prevent you from learning and improving. Keep a trading journey, wherein you record each of your trade along with the rationale behind the trade. The advantage of maintaining such a journal is that in future, you could refer back to the trades you made, analyse the rationale behind each trade, and compare that rationale with how the trade actually panned out. This way you will constantly keep learning from your past actions and also keep hindsight bias in check.
It is commonly believed that the pain of losing is twice as powerful as the joy of gaining. One of the most significant and influential work on loss aversion was done by Amos Tversky and Daniel Kahneman in 1979, for which the latter was even awarded a Nobel Prize in 2002. Their work is called the Prospect Theory or the Loss Aversion Theory. This theory states that investors value gains and losses differently and that losses have a greater emotional impact on an individual than do gains of equal magnitude.
Think about this for a moment. Let us say that a trader made two trades simultaneously: A and B. In trade A, he made a profit of ₹10,000. On the other hand, in trade B, he suffered a loss of ₹10,000. Notice that net-net, his capital remained unchanged (let us ignore the transaction costs here), as the gain in one was offset by a loss in the other. What do you think will be the mood of the trader? Do you think he will be happy as one of his trades worked well, neutral as his capital is unaffected, or disappointed because he suffered a loss in one of the trades? Well, more often than not, a trader would be disappointed. The pain of losing money in one trade will affect him more than the joy of gaining money in the other trade.
Loss aversion bias can have a profound effect on trading. For one, the mere fear of a loss could prevent a trader from taking a position or could cause him to hesitate when taking a position. What impact does this have on one’s mind? Well, let us first consider the former. If fear of loss prevented a trader from taking a position but then the trade worked out very well, the trader would regret why he or she did not take the position. This will emotionally drain the trader even more. Now, let us consider the latter. If fear of loss caused a trader to hesitate when taking a position, then even a small unfavourable price move can reinstate the trader’s loss aversion worries and cause him or her to panic. Meanwhile, loss aversion bias could also cause a trader to deviate from his or her trading plan by doing things such as reducing the position size, keeping tight stop losses etc.
Occasionally, when in a losing position, traders could also go to the other extreme. Rather than exiting the position at a stop loss, loss averse traders could hold on to the position hoping to exit either at cost or at some profit. This can turn out to be very dangerous, as the losses could keep mounting if price continues moving against the trader and eventually cause him or her to exit with a significant loss that could cripple the trading capital. All of this could cause a trader to take sub-optimal trading decisions, which in turn could act as a hindrance in achieving overall trading success.
How to overcome loss aversion bias?
Because of the repercussions that loss aversion bias could have on trading, it is important to not get influenced by it. But how does one control it? Well, whenever you trade, always do so with an open-mind. Accept that losses are a part of the game and that you will suffer losses at some point or the other. What is important is to accept losses and learn from them, so that you can constantly keep improving your trades. By all means, ensure that loss aversion does not influence your decision to deviate from your trading plan by taking excess risk to cut down on your losses or very low to no risk to avoid losses altogether.
Sometimes, traders do not have a view on a security but still end up trading it. You may wonder, why would anyone do that? Well, in a strongly trending market, there is a tendency for people to jump into the bandwagon and follow the crowd, even if they themselves do not have any particular view on the security. Occasionally, people could have a contrarian stance on the security. However, because of fear that they could be proven wrong, they could still end up following the crowd. This biasness of doing what others are doing, without your own research and analysis, is called the bandwagon effect or the bandwagon bias.
One of the key psychological reasons why traders exhibit bandwagon bias is to ensure that they do not miss out on the price move (recollect FOMO from chapter 1). This is especially true during the latter stages of a bull market, when everybody is buying and trying to capitalize on the price surge. Similarly, such a behaviour is also common during the latter stages of a bear market, when everybody is liquidating their positions because others are also doing the same. Following the crowd provides some sort of reassurance to traders that they are making the right move and that if they go wrong, they are in the majority.
As we can see, bandwagon bias affects the decision-making ability of traders and causes them to act based on what others are doing rather than act on the basis of their own judgement. When under the influence of herd mentality, traders tend to take decisions emotionally, which could cause them to deviate from their trading plan. Hence, it is important to keep your emotions under check and ensure that you do not get swayed by what the crowd is doing.
How to overcome bandwagon bias?
While there is nothing wrong in following the crowd, you must ensure that you are not doing so blindly. That is, you should not buy (sell) just because everyone around you is buying (selling). Instead, the trading decisions you take must be based on your own analysis and signals generated by your trading system. If your trading system agrees with what the crowd is doing, you can consider trading in that direction. If not, it is better to avoid following the crowd.
Also, it can be helpful if you start thinking contrarily, especially when the market has run up or down quite substantially. This doesn’t mean you should take a counter position right away. Instead, you should adopt a neutral stance and analyse the factors to gauge whether the current trend has further leg to go. For instance, in case of an uptrend, if your analysis suggests that most of the positives have been discounted and that the price rally is now overextended, you should exercise caution when following the crowd. If you get a confirmation that the prevailing trend is reversing/has reversed, you could take a contrary position and trade against the direction of the crowd.
Dealing with Biases and Emotions - Part 14 Lessons
Emotions cannot be altogether eliminated, but can be efficiently managed through discipline and a systematic trading plan. In this chapter, we will talk about some of the ways in which a trader could manage his or her emotions.
Dealing with Biases and Emotions - Part 27 Lessons
In this chapter, we will continue with where we left of in the previous chapter and talk about the rest of the important ways of dealing with biases and emotions.
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