Trading biases can largely impair our ability to read the market objectively and make sound trading decisions. We can overcome these biases only by becoming fully aware of how they influence our decision-making in the market.
This article examines five of the most common trading biases and how to deal with them so you don’t get in the way of your own success.
What are Trading Biases, and Why are They Important?
To correctly answer what trading biases are and why they are essential, it’s crucial first to understand what a cognitive bias is and how it occurs.
Cognitive bias is a subconscious but systematic thought process that occurs when our brain takes a mental shortcut while processing information. This mental shortcut is caused by our tendency to prioritize and quickly process large amounts of information by filtering it through our personal experiences and preferences. Alternatively, a cognitive bias is a clouded judgment of a situation.
As a result, cognitive biases impact how we make decisions and affect our actions.
With that in mind, a trading bias is a cognitive bias that affects our decision-making process when it comes to trading. These biases can be caused by various factors — emotions, past experiences, and even our physiology — and ultimately lead to irrational decisions that can negatively impact our trading performance.
Why Do We Have Trading Biases?
As much as we like to think of ourselves as rational creatures, the fact is that the trading process is rife with psychological pitfalls, any of which can trigger a bias in our decision-making. There’s a lot of information to process, securities to sort through, buy/sell/hold decisions to make, and so on.
Often, market behavior can provoke biases to surface and affect our trading actions. For example, if the market starts trending in a particular direction over a short period, we may become subject to the “safety in numbers” bias and follow the herd. This could happen even if that action deviates from our trading strategy.
Additionally, when your money is at risk, it’s easy to let emotions stemming from personal experiences and irrational observations cloud your decision-making.
Overcoming these trading biases is crucial for making more rational and informed decisions, ultimately improving our trading performance.
The good news is that simply being aware of these biases is the first step to avoiding them or, at the very least, minimizing their impact.
The 5 Most Common Trading Biases
There are dozens of cognitive biases that can influence trading decisions. However, they aren’t all equally common. For the purpose of this article, let’s look at the five most widely-spread trading biases that you are likely to come across.
1. Confirmation Bias
Confirmation bias is a cognitive bias that refers to the tendency to seek out, interpret, or favor information that confirms our pre-existing beliefs or opinions. At the same time, it makes us ignore or discount information that challenges those beliefs.
In trading, confirmation bias can impact our decision-making process by leading us to selectively perceive and interpret information in a way that aligns with our existing beliefs without objectively evaluating all available data. This can result in making trading decisions based on incomplete or one-sided information.
Traders with strong opinions or biases about specific securities, markets, or trading strategies are most at risk of confirmation bias.
For example, if you’re bullish on a particular stock, confirmation bias will push you to only pay attention to information that supports your bullish view. That can include only reading positive earnings reports, favorable analyst ratings, and news articles highlighting the company’s success.
At the same time, you are ignoring any negative information that challenges your bullish bias, such as potential regulatory concerns, weakening industry trends, or negative sentiment from other market participants. Because of this, you might continue to hold on to your position despite signs of weakness in the stock’s performance.
Eventually, all the negative information you have ignored ends up impacting the stock, and its price drops significantly, causing substantial losses.
How to Avoid it
Simply try to be more open and willing to see the complete picture. Some tips to avoid or overcome confirmation bias as a trader include:
- Be objective in your research — prioritize information that provides a balanced and unbiased perspective.
- Challenge your own beliefs — practice self-reflection and open-mindedness to consider different viewpoints and potential risks. Be receptive to information even if it challenges your existing beliefs.
- Keep a trading journal — maintain a trading journal to track your trades, decisions, and thought process. This can help you regularly identify patterns of confirmation bias so you can adjust your trading approach accordingly.
- Follow a trading plan — stick to your trading plan and avoid impulsive decisions based on biased beliefs.
2. Herd Mentality Bias
Also known as herd behavior or herd instinct, herd mentality bias refers to the tendency of traders to follow the actions or decisions of the majority of the “herd” without independently evaluating an investment’s underlying fundamentals or risks.
This bias is primarily driven by the belief that since everyone else is doing it, it must be the right decision.
As a trader, you risk falling victim to herd mentality bias if your trading decisions are primarily influenced by the actions or opinions of other traders. It can also occur if you are quick to follow trends, fads, or market sentiments without fully understanding the underlying risks or fundamentals of the trade.
Herd mentality bias is one of the most profound trading biases because it can also impact the broader market environment. When a larger number of traders collectively make irrational decisions based on the actions of others, it can lead to the formation of market bubbles and trigger crashes.
How to Avoid it
Here are some strategies to overcome herd mentality bias as a trader:
- Conduct independent research — be thorough with your research and avoid making trading decisions solely based on rumors, market sentiments, or the actions of others.
- Practice contrarian thinking — this is a great way to challenge the herd mentality because it encourages you to take a different stance from the majority. Remember that the fact that everyone is doing it doesn’t mean everyone is right – it can equally mean that everyone is wrong.
- Trust your own analysis — have confidence in your own reading of the market situation and the trading plan you have in place. This makes it harder to be swayed by herd behavior.
3. Overconfidence Bias
Also known as overestimation bias, overconfidence bias refers to the tendency to overestimate your abilities, knowledge, or the accuracy of your predictions. This leads to an inflated sense of confidence in your trading decisions, which can result in taking excessive and unnecessary risks.
Usually, traders who have experienced recent trading success are most at risk of overconfidence bias. They start to develop a feeling of “I can’t go wrong” whenever they make a trading decision. Fueled by their false sense of superior ability to predict market movements, they start taking larger positions and higher risks.
How to Avoid it
At its core, the key to overcoming overconfidence bias in trading is to understand that the market is largely unpredictable. Therefore, you can’t be right all the time.
Some proven tips for avoiding this type of trading bias include:
- Seek feedback and advice — get advice from peers, mentors, or other experienced traders to gain an external perspective on your trading decisions.
- Set realistic expectations — this forces you to acknowledge that trading involves risks and uncertainties. It’s important to plan for those risks accordingly.
- Practice self-awareness — being mindful of how your thoughts and emotions influence your approach to trading can help you recognize when you may be feeling overly confident or optimistic about a trade. This way, you can take a step back to assess the risks involved objectively.
- Use objective criteria — these include technical analysis, fundamental analysis, and other data-backed tools to inform your trading decisions rather than relying solely on your own intuition or gut feelings.
4. Recency Bias
Recency bias, or availability bias, refers to the tendency to rely too heavily on recent or readily available information when making trading decisions. At the same time, neglecting older or less easily accessible information.
This trading bias can make you overly influenced by recent market events or trends, which may not always indicate long-term market patterns or trends. It can also contribute to herd mentality market behavior.
If you’re the kind of trader who tends to focus solely on short-term market movements and news rather than taking a more holistic and long-term view, you may be at risk of recency bias.
For example, let’s say you’ve been closely following a particular stock performing well in recent weeks. Based on this recent trend, you decide to go all-in and invest a significant portion of your capital in the stock.
Unfortunately, the stock starts to decline in value shortly after your investment, as the recent trend reverses. That’s when you realize you’ve fallen victim to recency bias because you solely relied on recent information without considering the broader market context or historical data.
How to Avoid it
Some strategies to help you avoid or overcome recency bias as a trader include:
- Follow a systematic approach — this involves making trading decisions based on a well-defined set of criteria rather than making impulsive decisions based on recent trends or events.
- Practice critical thinking — this forces you to question the validity and reliability of the information you receive before making a trading decision.
- Take a long-term view — trading is a marathon, not a sprint. Avoid jumping to conclusions based solely on recent information and seek multiple perspectives and sources of information.
5. Loss Aversion Bias
Loss aversion is the tendency to strongly prefer avoiding losses over acquiring gains of an equivalent value. In other words, traders tend to feel the pain of losses more intensely than the pleasure of gains, resulting in irrational trading decisions.
You are at risk of loss aversion bias if you have a strong emotional attachment to your investments. In that case, you are more likely to focus on avoiding losses rather than objectively assessing market conditions.
Loss aversion bias can result in traders holding on to losing positions for longer than they should, hoping the market will reverse. It can also lead to selling winning positions prematurely to lock in gains, even if the market conditions may indicate otherwise.
How to Avoid it
Some helpful tips for overcoming loss aversion bias include:
- Set clear stop-loss and take-profit levels — stick to them, and don’t let emotions influence your decision-making when closing a trade.
- Practice disciplined risk management — this can help you objectively manage your trades and avoid becoming overly attached to losing positions.
- Focus on probabilities, not absolutes — trading is a game of possibilities, so losses are unavoidable. By focusing on your trades’ probabilities and statistical outcomes, you can better detach your emotions from individual trades or investments.
Historical Examples of Trading Biases and Their Impact
There are several instances where trading biases have heavily impacted financial markets.
One example is the Dotcom Bubble of the late 1990s. Due to widespread overconfidence bias, traders and investors went into a speculative frenzy, pouring billions of dollars into internet-related stocks. Alas, the bubble burst, and the stock market crashed, taking their investments with it.
A more recent example is the GameStop short squeeze of 2021. During this event, a group of retail traders on social media teamed up to drive up the stock price of GameStop after the stock was heavily shorted by institutional investors. This led to a massive short squeeze that resulted in significant losses for the institutional short-sellers.
The GameStop short squeeze is a glaring example of herd mentality bias because as the price increased, more and more traders continued to buy. Eventually, the short contraction subsided, and the stock price returned to more reasonable levels, resulting in substantial losses for those who bought at the peak.
Conclusion
Overcoming biases is a crucial step in becoming a more successful and profitable trader. This includes developing a well-defined trading plan, following risk management techniques, staying informed, performing data-backed analysis, and maintaining emotional discipline in your decision-making process.
Regularly reviewing and learning from your past trades can also help you identify and mitigate any biases that may be impacting your trading performance. Keeping a disciplined and objective approach to trading is a proven recipe for better decision-making.
