There is an extremely famous psychology paper written by Daniel Kahneman and Amos Tversky named ‘Judgement Under Uncertainty: Heuristics and Biases’ (psiexp.ss.uci.edu/research/teaching/Tversky_Kahneman_1974.pdf) (Kahneman won a Nobel Peace Prize in 1992 for his work in the field, specifically on prospect theory) which explores the decision making process.
As trading requires decisions to be made constantly – stop loss adding, lot size, whether a trade is right to take etc – I think a quick write up would be highly applicable.
Essentially, there are several ‘heuristics’ or ‘biases’ which I will attempt to put into a trading context. 1) Reliability. Making sense of data on the spot is a difficult task to undertake. When you look at a chart, you are looking at a representation of the market and not the actual market. Adding more and more indicators causes the reliability of this data to further decrease, possibly leading to a distorted view (however, if you are profitable with indicators then that is all that matters). 2) Representation. We normally feel that if a pattern is forming that it will play out in the way we expect. When back testing, you may look for data to represent the notion you have about a certain set up and ignore the set ups that have failed, therefore leading to a skewed view of that strategy. Indicators represent a potential set up and not what is actually occurring – indicators are used to fit a concept in your head. The fact that something is more representative does not make it more likely to occur.
3) Anchoring. Do you remember that month when you did fantastically and the next month you lost 5% of your account under the belief you could continue your run and then possibly ditched your strategy to start from scratch? This is called anchoring – you place some meaning on a certain set of results with the thought that the initial point is meaningful. You will face losses. Maybe even a quarter where you make no money. On the flipside, you may triple your account. The market is impartial to you, your strategy and your money.
4) The Gambler's Fallacy. When an event occurs more or less is a short time period, you may believe that it will happen less or more in the future. As said before, the market is impartial. Past events do not change the probability of future events occurring.
5) Hindsight bias. ‘I knew that was going to happen’. This is reasonably self explanatory and I think everyone has faced this once or twice (maybe nearer 1000) times in their trading career!
Automated traders do not have the problem of biases as the emotion is taken out of the trade, which is why possibly developing an algorithm can be hugely beneficial if you have a stringent set of rules that you can programme into a computer.
There are many more biases. Which have you noticed in your trading?