6 IRRATIONAL BEHAVIOR AND THINKING PATTERNS - THINKING CLEARLY !
Hello everybody and welcome,
I hope you'll have a pleasant time reading this. And I also hope it'll somehow be useful to you.
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Let's face it, your biggest enemy in trading is not the market, not the hedge funds, not the banks, it's you. Thinking clearly is one of the hardest things to do when trading/investing.
We've all, at least once, done something and asked ourselves afterwards, "why did I do this ?" or "how didn't I see this" ? Did you know that this is called the "Hindsight bias" ? Yes, it's a well-known phenomenon in psychology.
Before we begin, let me explain the diagram. Developing clear thinking takes time. You'll find it very hard at first, but as time goes by, if you keep your focus on it, you'll notice your performance increasing exponentially (this also applies to your life in general !).
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1. Confirmation bias
The confirmation bias, is the distortion of information to make sure that it fits our beliefs. Let's think about it that way : if you think that the world is an awful place, you'll find facts to back your belief about the world. What happens when you encounter a fact that denies your belief ? You either ignore it or distort it in order to make it fit your belief.
It's about the same thing when you're trading. Sometimes, especially new traders, hold bags, meaning that they hold on to losing positions for a long time, hoping for a recovery. No matter what, the trader will find himself putting more weight on the information that confirm his belief (that he's right) and will ignore the information that refutes it (that he's wrong and should sell).
In order to avoid the confirmation bias, you need to weigh every new information the same way.
2. Hindsight bias
The hindsight bias, is directly correlated to the confirmation bias. We tend to understand things better in hindsight than we do in the present moment. To take the previous example of the trader that holds bags a little further : what happens when the trader decides to cut his losses ? He immediately says : "Oh, all the information I had indicated a clear downtrend, why didn't I cut my losses earlier ?". The hindsight bias. In hindsight, everything appears to make sense.
In Trading, the best way to avoid this bias, is to reactto the market information that's available to you, rather than trying to predict it or to hope for something to happen. In other words, when you have an edge, you trade your edge and you remain open to any information the market gives you, be it information that confirms or invalidates your initial belief.
3. Loss aversion
We feel better losing nothing than winning something - say hello to loss aversion. Overall, humans are more sensitive to negative things than to positive things. Think about how much we complain. Sometimes, it's justified, but often it isn't. We complain about things we don't have, but omit to be grateful for everything we have.
In trading, loss aversion, is the pattern that makes us hold on to a losing position for a long time. After all, an unrealised loss is less painful than a realised one. To avoid loss aversion, you have to work on your mindset and start thinking in probabilities.
4. Outcome bias
This is another very, very important psychological trait that messes with our trading. Human beings tend to judge a decision by its outcome, rather than gauging the decision process. In the best case scenario, you have an edge and you act on that edge every single time you see it appearing on a chart.
The problem is, because trading is all about probabilities, sometimes, your edge won't work. Does this have something to do with the process ? Absolutely not, it's just how trading works. But, when you aren't aware of it, you start questioning your trading strategy, even though, the outcome is not correlated with the process. Just be aware that the outcome is not a reflection of the process.
5. Action bias
Whenever we do something to compensate for our inaction, we fall for the action bias. We rather do something useless than nothing at all. If you watch football, you've probably witnessed this bias a lot of times. When the opposing team shoots a penalty, the goalkeeper, either dives left or right, even if chances are that the opposing player shoots right in the middle. Why ? Well, diving looks way better than just standing still, whatever the result is.
As Jesse Livermore would say, "Money is made by sitting, not trading". Considering this bias, for us human beings, it is hard to sit and do nothing. Just think about what you do when you have to wait, be it in a waiting room or at the bus stop. This could be an explanation why most traders fail. They struggle letting their trades unfold and get caught into thinking that their inaction is harmful. Eventually, they end up overtrading, taking trades they otherwise wouldn't, to avoid inaction.
"All of humanity's problems stem from man's inability to sit quietly in a room alone", Blaise Pascal.
6. Overconfidence effect
Overconfidence is a very evil trait to trading. When we are overconfident, we tend to overestimate our knowledge and take bigger risks. Financial markets are unforgivable with overconfidence. Markets really are unpredictable, therefore we shouldn't even try to predict them.
We need to go with the opporunities that the markets make available to us. The best traders are aware of it, therefore they try to be humble and respect the markets. As an example, we could imagine a trader that is on a 5-trade winning streak. He feels great, he feels invincible. What happens ? He takes bigger risks and one day he'll inevitably issue a huge loss.
I hope you'll have a pleasant time reading this. And I also hope it'll somehow be useful to you.
---------------------------------------------------------------------------------------------------------------------------------
Let's face it, your biggest enemy in trading is not the market, not the hedge funds, not the banks, it's you. Thinking clearly is one of the hardest things to do when trading/investing.
We've all, at least once, done something and asked ourselves afterwards, "why did I do this ?" or "how didn't I see this" ? Did you know that this is called the "Hindsight bias" ? Yes, it's a well-known phenomenon in psychology.
Before we begin, let me explain the diagram. Developing clear thinking takes time. You'll find it very hard at first, but as time goes by, if you keep your focus on it, you'll notice your performance increasing exponentially (this also applies to your life in general !).
---------------------------------------------------------------------------------------------------------------------------------
1. Confirmation bias
The confirmation bias, is the distortion of information to make sure that it fits our beliefs. Let's think about it that way : if you think that the world is an awful place, you'll find facts to back your belief about the world. What happens when you encounter a fact that denies your belief ? You either ignore it or distort it in order to make it fit your belief.
It's about the same thing when you're trading. Sometimes, especially new traders, hold bags, meaning that they hold on to losing positions for a long time, hoping for a recovery. No matter what, the trader will find himself putting more weight on the information that confirm his belief (that he's right) and will ignore the information that refutes it (that he's wrong and should sell).
In order to avoid the confirmation bias, you need to weigh every new information the same way.
2. Hindsight bias
The hindsight bias, is directly correlated to the confirmation bias. We tend to understand things better in hindsight than we do in the present moment. To take the previous example of the trader that holds bags a little further : what happens when the trader decides to cut his losses ? He immediately says : "Oh, all the information I had indicated a clear downtrend, why didn't I cut my losses earlier ?". The hindsight bias. In hindsight, everything appears to make sense.
In Trading, the best way to avoid this bias, is to reactto the market information that's available to you, rather than trying to predict it or to hope for something to happen. In other words, when you have an edge, you trade your edge and you remain open to any information the market gives you, be it information that confirms or invalidates your initial belief.
3. Loss aversion
We feel better losing nothing than winning something - say hello to loss aversion. Overall, humans are more sensitive to negative things than to positive things. Think about how much we complain. Sometimes, it's justified, but often it isn't. We complain about things we don't have, but omit to be grateful for everything we have.
In trading, loss aversion, is the pattern that makes us hold on to a losing position for a long time. After all, an unrealised loss is less painful than a realised one. To avoid loss aversion, you have to work on your mindset and start thinking in probabilities.
4. Outcome bias
This is another very, very important psychological trait that messes with our trading. Human beings tend to judge a decision by its outcome, rather than gauging the decision process. In the best case scenario, you have an edge and you act on that edge every single time you see it appearing on a chart.
The problem is, because trading is all about probabilities, sometimes, your edge won't work. Does this have something to do with the process ? Absolutely not, it's just how trading works. But, when you aren't aware of it, you start questioning your trading strategy, even though, the outcome is not correlated with the process. Just be aware that the outcome is not a reflection of the process.
5. Action bias
Whenever we do something to compensate for our inaction, we fall for the action bias. We rather do something useless than nothing at all. If you watch football, you've probably witnessed this bias a lot of times. When the opposing team shoots a penalty, the goalkeeper, either dives left or right, even if chances are that the opposing player shoots right in the middle. Why ? Well, diving looks way better than just standing still, whatever the result is.
As Jesse Livermore would say, "Money is made by sitting, not trading". Considering this bias, for us human beings, it is hard to sit and do nothing. Just think about what you do when you have to wait, be it in a waiting room or at the bus stop. This could be an explanation why most traders fail. They struggle letting their trades unfold and get caught into thinking that their inaction is harmful. Eventually, they end up overtrading, taking trades they otherwise wouldn't, to avoid inaction.
"All of humanity's problems stem from man's inability to sit quietly in a room alone", Blaise Pascal.
6. Overconfidence effect
Overconfidence is a very evil trait to trading. When we are overconfident, we tend to overestimate our knowledge and take bigger risks. Financial markets are unforgivable with overconfidence. Markets really are unpredictable, therefore we shouldn't even try to predict them.
We need to go with the opporunities that the markets make available to us. The best traders are aware of it, therefore they try to be humble and respect the markets. As an example, we could imagine a trader that is on a 5-trade winning streak. He feels great, he feels invincible. What happens ? He takes bigger risks and one day he'll inevitably issue a huge loss.