Introduction :

The stock market is a picture painted by the human emotions. The human mind is a battle field. A trader must first learn to fight his own cognitive biases before going on to a war with the market.

In this article we are going to discuss some of the most common cognitive biases that a trader has to go through and towards the end, we will find out ways to deal with them.

Common Types of Cognitive Biases :

1) Anchoring Bias

I) Anchoring Bias : We tend to give more weight to the first piece of information that we receive. This first piece of information is referred as an anchor. Eg. If you walk into a mall today and find the price of your favourite watch to be $500 which is at 30% discount from the price that you had seen a few months back, you will be much more willing to pay and buy the watch today as the initial price is anchored in to your mind and now you’re getting it for a cheaper price. Same happens when people trade.

2) Loss Aversion Bias

II) Loss Aversion Bias : Given same magnitude of loss and gain, the trader will experience less joy when he gained as compared to the grief he experiences during the loss. Due to this, traders tend to hold on to losses because they do not want to realize the loss. Not realizing the loss (closing the position) gives them a hope and they end up taking no action and making more losses. Eg. If a trader made $100 on a trade and lost $25 on the other, the loss of $25 will overpower the joy of making $100, and so he might end up holding the losing trade in a hope for it to turn profitable just to avoid the grief that comes along after booking a loosing trade.

In the graph below, We can observe that for the same degree of loss, a person goes through much more pain as compared to the pleasure that he might experience from a same degree of loss.

Picture depicting Degrees of emotions from pain and gain.

3) Confirmation Bias

III) Confirmation Bias : This bias affects a the person in a way that he starts giving more weight that supports his belief and less weight or importance to the information which acts against his belief. It creates a kind of a filter in the mind of the person which keeps ignoring the information that goes against the belief of the person. Eg. If a trader has entered a position and gone long on some instrument, he will be more prone to searching for news articles and news which support his notion rather than doing the otherwise.

4) Post Purchase Rationalization

IV) Post Purchase Rationalization : Also known as choice supportive bias is a tendency to retrospectively attribute positive characteristics to the stock that they have purchased and overlook any negative characteristics. Eg. If a trader has bought a stock and it is going down due to a general downtrend in the economy, they will still try to justify the stock by saying that they have best product in the industry, the management is the best even-though it might not be the best but just good enough.

5) Hindsight Bias

V) Hindsight Bias : It is a phenomenon in which the trader overestimates his ability to have predicted the outcome of an event that they would not have been able to predict so confidently before the event occurred. Eg. Triangle is a very popular trading pattern. If someone spots it on the charts in the hindsight, he would have a very good confidence over this ability to have spotted the pattern, trading it and making profits from it, which might not actually be true when he is looking at the pattern while it is forming in the live market.

How does it affects the traders ?

These biases can easily handicap even the most experienced. When you are at your trading desk, there is a tsunami of emotions going through your head. Our brain’s gating mechanism might not be powerful enough to allow us to rationally focus on our trade. Lets go ahead and list down some of the practical consequences of these biases :

Entering The Trade Impulsively Exit trades too early Hold losing trades to the point of completely forgetting the trade Irrationally justifying the market and the stock movement Developing a herd mentality

What can be done to escape the trap of the cognitive biases ?

Systematic trading is the only way through which one can avoid falling into these traps. It is a mechanical trading approach wherein the rules are predefined and there is no room for compromise or changing the rules on one’s discretion without following any analytical approach. One might refer to other posts especially this one to learn how a trading system and risk management approach can help maximize profits and limit losses. Certain platforms like Streak allows one to create, backtest and automate their strategies without any knowledge of coding. It comes with no learning curve what so ever.