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Cognitive bias and heuristics which influence a financial trader’s performance.

Think about this question… How do we make sense of an event?

Does our mind take a running dialog of every specific thing that happens during the event? Well the answer is no. To make sense of an event we tend to simplify it. We consider two aspects, 1. the peak of how good it was and 2. how it ended.

In trading, we can fall victim to behavioural issues which are a result of how we perceive our experience. Some of these behavioural outcomes are; fear of entering a trade after losses, fear of missing out, allowing losses to run and cutting winning trades short. Of course, there are many more, but we must realise these are secondary symptoms to fundamental and inherent issue. These are called cognitive biases.

What is a cognitive bias?

A cognitive bias is a systematic error in thinking which affects decision making and judgement. Sometimes it is related to memory or it can be related to attention; where limited access to information creates a selective view of the world. In short, our judgements and decision have errors, and these can come from our subconscious.

Cognitive biases are a way we simplify information to arrive at quick decisions. This is a mechanism of mentally short-cutting to speed up decision making and thinking. These are also called heuristics. Don’t be upset though, we all have heuristics which are believed, by psychologists, to be a mechanism to adapt to a change in environment or situation and most likely to be a method of survival.

Confirmation Bias

Confirmation bias is a tendency to view an environment or form an opinion in a one-sided way, focusing on one possibility and not alternatives. People can also interpret ambiguous evidence to support their pre-existing beliefs or hypotheses. This attitude polarisation is led by biased research, interpretation and memory. When emotional reactions run high it increases further belief persistence, even if the evidence is proven incorrect, it causes a greater reliance on earlier information.

In layman terms, traders tend to decide based on limited information, incorrect evidence and beliefs which the evidence may clearly define the contrary. Confirmation bias creates a hubris in investors opinion of their strategy and prevents them from forming a complete picture of reality.

Availability Heuristic

The availability heuristic is a cognitive short-cutting process that considers recent events or immediate examples to form an opinion, topic, or method. It operates on the notion that if a person can recall something then it must be important or at least more so compared to alternatives. This means people tend to weigh their thinking or judgements toward more current information which creates a bias toward recent events.

The Availability heuristic also acts as a measure to reach a magnitude between the perception of actions and the consequences of that action. To explain further, the easier it is to recall consequences the greater the consequence is perceived to be. This availability to consequence leads traders to become fearful.

Can this be fixed?

In short, yes. Trading is not an easy game. Most retail traders seem to think they can do it on their own. Unfortunately, this is not the case. In fact, 97% of retail traders fail but with the right coaching or mentorship from experienced traders over a period long enough to train their cognitive behaviour they have a greater chance of success. This level of training holds the student accountable for their actions which most certainly cannot be achieved on their own.

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Wilfred Waters
Wilfred Waters

My first degree was psychology. My honours thesis was about the impact of emotion during negotiations, a key activity in business and also relates to trading. Trading is basically all about negotiation. Everywhere I turn in the trading world I see experts warning that the most significant source of error amongst participants is emotions. Yet, all the books I've seen experts recommend I read appear to have nothing directly to do with the impact of emotions on trading. This is not to deny they're useful. It's just that there is a divergence, to use a trading term, between what the experts warn new participants such as me about, and what they write about.

Edit: I just discovered a trader psychology…


Great post Richard.

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