OAP 162: The Top 8 Investor Biases That Cloud Our Judgement When Trading

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It might seem that the markets are a game of price, and while that might be mostly true, what they are is really a game of emotions. With enough self-awareness the "average" investor can do incredibly well. Better than many sophisticated investors.

There's so much to be said about controlling your emotions and recognizing biases that we could spend hours upon hours dissecting each one. I prefer a more optimized approach which is why I decided to do a podcast specifically on the top 8 biases that investors fall victim to. Once you learn to recognize them, you can then process the emotions behind the scenes so that it doesn't interfere with your trading.

Key Points from Today's Show:

1. Confirmation Bias

  • The cognitive belief bias where people overemphasize any idea that confirms their own beliefs or devalues other ideas that contradict with their beliefs. 
  • When you are trading and you see something that confirms what you thought to be true about trading, you put all of your focus on that one thing. 
  • This is dangerous because you write off other ideas just because you don't agree with them. 
  • Instead, you should be flexible enough that you can accept and process new information.

2. Loss Aversion Bias

  • Most investors have a really strong desire to avoid losses. 
  • Often times investors will put twice as much effort into avoiding a loss as they will into taking a really good win. 
  • In reality, we know we can't avoid a loss. 
  • Instead, accept the loss, don't mask it, and take the loss.

3. Recency Bias

  • When recent events are overemphasized to those that happened in the past. 
  • In trading, when the market has been one way for a few months or years, we often think it will continue to be that way.
  • This is where backtesting and looking at case studies can really help.
  • You have to test a strategy and look at the performance over a long-term period.

4. Control Bias

  • As traders, we want to control things and have an innate thought process that we have control over the markets. 
  • In fact, you have no control over the market. 
  • All you really can control with trading is what positions you enter and the position size. 
  • Instead of falling prey to the illusion of control, accept that you cannot control external factors.

5. The Gamblers Fallacy

  • When you get into winning streaks and sequences of returns, traders often get the feeling that the results have to be different or the odds have changed.
  • Just because there was a streak of one result in the past does not mean it's going to turn over and give a different result next. 
  • Instead, recognize that the odds are still the same as they were when you started.

6. Geographical Bias

  • We are creatures of our surroundings and have a very strong bias to our own geography.
  • That bias leads people to only invest in their home country or industries they are surrounded by. 
  • Instead, investing in emerging markets will give your portfolio the diversity it needs. 

7. Cognitive Dissonance

  • Often investors will ignore newly acquired information because it conflicts with previous views. 
  • If the new information conflicts with how you believe your portfolio should be structured, then you discard that information as irrelevant. 
  • Instead, incorporate new information and use it to redirect your strategy and focus. 

8. Endowment Effect

  • The idea that what we own is more valuable right now because of the fact that we own it. 
  • If we didn't own it, we might not place as much value on it. 
  • This happens a lot with traders who own stock in companies that they like. 
  • Instead, consider if you didn't own it, would you buy it at that price?

BONUS: 

9. Self-Attribution Bias

  • Bias where any investor or trader has a tendency to credit their success to some talent or skill that they have. 
  • They also blame failures on situations that are beyond their control. 
  • As traders, we easily fall into this category.
  • Don't want to get into a cycle of doing things you've always done after acquiring new information. 
  • Instead, recognize that your emotional intelligence ends up becoming the most profitable asset that you have.

Option Trader Q&A w/ Mikael

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today's question comes from Mikael:

My question is regarding the at the money strike pricing. Right now I'm looking at ACN, May 18th 145 strike. The mid-point right now is 590 for the calls and the puts are priced at 425. I always notice this discrepancy and I was hoping you could shed some light on that?”

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

Thank You for Listening!

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.