The 5 Most Common Trading Biases

Battling with the mind has a trader’s biggest battle since the inception of markets themselves.

Cognitive biases have been a trader’s biggest battle since the dawn of markets themselves.

Preventing the trader from making a decision based on sound reasoning, biases mess with the trader’s emotional state and cloud judgement, often resulting in financial losses—immediately or over time.

Understanding and accepting cognitive biases can enable a trader to cautiously yet meticulously work on improving their mindset. A clear and calculated mindset will increase a trader’s chances in the markets.

Read on if you’re wondering about the more common trading biases and how to identify them.

A cognitive bias can cause an individual to come to conclusions based on emotions or ill-informed assumptions rather than reasoning. 

Trading is an area where cognitive biases are rampant, since the act of making and losing money brings with it an awful lot of emotional impact.

To understand the root cause of cognitive biases, it is essential to learn about the field of behavioural psychology.

Behavioural Psychology & Behavioural Finance

Behavioural psychology is the scientific study that seeks to understand the impact of emotions in the decision-making process of humans, especially as a reflex in relation to stimuli.

While making a trade, a trader can feel various emotions such as fear, nervousness, and overconfidence, affecting their decisions. For instance, an emotional trader may prematurely sell a security only because of fear that the price might decrease, rather than based on any factual evidence. 

Let’s have a look at the 5 most common cognitive biases experienced by traders.

• Confirmation Bias

Confirmation bias is essentially when you ignore everything but information that confirms your beliefs. For instance, if you believe the market will rise but are suffering from confirmation bias, you will ignore all the signals that suggest otherwise—even past the point of invalidating your original hypothesis.

• Anchoring

Anchoring is a bias in which the trader is influenced—or “anchored”—to a specific reference point. This can be anything from an earnings estimate or even a price (such as the trader’s entry price on a position—often resulting in them trading their PnL and not the market).

Having a reference point is not necessarily a bad thing, but it becomes biassed when the trader gives too high of a weightage to a single factor and neglects other factors that could impact the trade. 

• Loss Aversion

Losing money is painful, that’s undeniable. But if you want to become a top trader, you must learn to deal with it.

Loss aversion is a bias in which the “emotional damage” of taking a loss is more impactful than the equivalent return. One of the unwritten trading rules for success is to “cut your losses and let your profits run”, but loss aversion can cause the trader to be unable to accept losses.

• Recency Bias

Recency Bias is an error that occurs when the trader makes decisions based on recent outcomes in the financial market. 

If a certain pattern is occurring in the market, a trader might think that this is the next winning strategy, not realising that it may be temporary or only working due to specific circumstances at the time (such as the current market cycle, etc.).

This bias causes the trader to neglect logic and do the same thing over and over again, without considering the consequences. 

• Clustering

Like the stories of people lost in the desert seeing the mirage of an oasis in the distance, clustering bias in trading occurs when a trader sees trends in the randomness. This can cause the trader to make moves which they believe are based on reality, when in fact are no better than a coin flip.

While trading is all about filtering the signal from the noise, it is crucial to understand the basis on which any pattern is built upon before utilising it in a trading strategy.

Financial markets can be wild and volatile, but nevertheless, each and every decision should be made based on sound reasoning and logic, not emotions.

Understanding these common biases in trading can allow you to avoid making  the same mistakes many other trades make.

Bookmap shows you inside the real market, which can be a great aid when trying to avoid biases. Click here to get started.