The Top 8 Investor Biases that Cloud Our Judgement when Trading
It might seem like 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.
1. Confirmation Bias
- The cognitive belief or bias where people overemphasize ideas that confirm their own opinions or devalue other ideas that contradict their beliefs.
- When you are trading and you see something that confirms what you thought to be true, you put all of your focus on that one thing.
- This bias 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, 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 losses.
- Instead, accept the loss, don't mask it, and take the loss.
3. Recency Bias
- When recent events are overemphasized compared to those that happened in the past. For example, thinking that since it has been sunny the last seven days, it will be sunny forever.
- 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. Longer-term backtesting gives perspective of the range of possibilities.
- 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 desire to have control over the markets when, in fact, we 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 Gambler's Fallacy
- When traders get on winning streaks or sequences of returns, they 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 (such as multiple up days in a row) does not mean the next result has to turn the trend around.
- 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.
- Geographical bias leads people to invest more in their home country or in industries they are surrounded by geographically--such as financials if you live in the northeast U.S. or oil and gas if you live in the southwest.
- Instead, investing in emerging markets, for example, will give your portfolio the diversity it needs compared to having a geographical bias.
7. Cognitive Dissonance
- Investors often 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 already own a security, would you buy it at today’s price?
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 tend to blame failures on situations that are beyond their control.
- As traders, we easily fall into this category when we take credit for our successes and blame our failures on something or someone else.
- We don't want to get into a cycle of doing things we've always done despite having acquired 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 ATM strike pricing. Right now, I'm looking at ACN, May 18th 145 strike. The midpoint right now is 5.90 for the calls and the puts are priced at 4.25. 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