Have you ever thought about how your brain can trick you into making poor trading decisions? I know my brain plays tricks on me all the time, and there is actually scientific research to prove this isn't just our imagination. Cognitive biases are a common problem for traders of all levels.
What is it?? A cognitive bias is a mental shortcut that leads to inaccurate judgments. These shortcuts may be helpful in some situations, but they also tend to lead to errors in our trading.
There are many different cognitive biases but the most common include:
Overconfidence bias: This bias leads traders to overestimate their own abilities and make riskier trades than they should. Your put sale strategy is doing so well, you start feeling like your an expert. You might even start to think you've got this market thing down. Be careful though, because overconfidence can make you underestimate the risk involved in trades. Remember, no strategy works all the time, even if you feel like you can't lose do not take outsized risks because even the pros have losing months or even years.
Confirmation bias: This bias leads traders to seek out information that confirms their existing beliefs and ignore information that contradicts them. Do you have that underlying that you just love? If we're honest most traders do. Confirmation bias happens when you are bullish on a particular stock so you pay more attention to indicators or patterns suggesting that the stock will rise (like an uptrend, strong earnings, or bullish candlestick patterns) so overlook indicators, news, or any analysis that suggests the contrary.
Loss aversion: This bias makes traders more likely to hold onto losing trades in the hope of recouping their losses. Here's a fun fact: We hate losing more than we love winning. Captain Obvious here I know... But that's loss aversion you might hold onto a losing trade too long, hoping it'll turn around, or sell a winning trade too quickly, fearing a loss. This is why you have to set targets and stop losses BEFORE you enter the trade. Cut your losses when you planned to cut your losses! Don't let a small loser turn into a bigger loss because you are afraid to lose. Losing is normal in trading, just win more than you lose by taking high probability trades!
Herd mentality: This bias leads traders to follow the crowd, even if they don't believe that the crowd is right. If all your buddies jumped off a bridge, would you? Hopefully not... In the market, it's easy to follow the crowd. Especially if you were waiting for the bottom, and the market takes off without you. Rarely have I seen people who YOLO in because everyone else is already in work out in their favor. Just remember, the popular choice isn't always the best choice. GKT enjoys the contrarian view of lets buy when people are selling, and lets sell when people are buying.
Hindsight bias: This bias leads traders to believe that they could have predicted past events, even though they actually couldn't have.This one holds a special place for me. I see so many experts who look back and talk about how easy trades are AFTER the fact they say things like "I knew that would happen!" This is hindsight bias, and it can make you underestimate or overestimate your own trading prowess. Reality check: predicting market movement is tough. Don’t let hindsight influence your your confidence in either direction. It's fine to look at the past, learn from past trades and update your plan. But people who describe hindsight trades afterwards are everywhere, don't become one of them. Focus on now.
Gambler's fallacy: This bias leads traders to believe that past events affect future outcomes, even though they don't. Just because you've had a string of losses, it doesn't mean you are due for a win. This is known as the gambler's fallacy. However, the market is not a casino. Each trade is independent of the previous trades. There is no such thing hot streaks" or "cold streaks." Do not let emotions, or dopamine hits turn your trading into a pull of a slot machine's handle. Stay mechanical in your trading, and trade your plan!
Recency bias: This bias leads traders to believe that whatever is happening now will keep happening, even though it may not. Just because your favorite stock has been climbing doesn't mean it won't plateau or drop. Calling tops or catching falling knives is tough. It's ok to take trades, just have rules and exit strategies. You miss 100% of the trades you don't take, just remember whatever is happening now doesn't have to continue.
Some things to consider to overcome cognitive biases include:
Be aware of your biases: The first step to overcoming cognitive biases is to be aware of them. It sounds obvious, but this is actually overlooked! Once you know what your biases are, you can start to watch for them and take steps to avoid them.
Use a trading plan: A trading plan helps you stay disciplined and avoid making emotional decisions.
Use risk management techniques: Risk management helps you to limit your losses and protect your profits.
Get feedback from others: Getting feedback from other traders can help you to identify and correct your biases. Have you heard about our GKT Discord?
Cognitive biases are a major obstacle to successful trading. By just being aware of your biases and taking steps to overcome them, you will improve your trading results. If you want to discuss cognitive biases in trading more join the GKT Discord. We have a community of traders who are all committed to helping each other become better traders. Happy trading Good Kids!