Congitive Biases

In a previous post, I talked about the Trend Volatility Line (TVL), one of the gems I gleaned from the Gold & Forex Masterclass 2009. Here's another interesting tidbit that I didn't have the time to write about until now - Congitive Biases.

One of the most important aspects (that I'm still working on) for trading, is self-awareness. Naturally, this means that one should also be aware of various cognitive biases that influences one's judgement and decision making. Here are some of the biases that Mr William Purpura shared during the masterclass. For some of these, I've taken the liberty to do a little desktop research to elaborate alittle more on some of these biases.

Sunk-Cost Bias: Acting to justify money already spent.
Sunk-Cost Bias doesn't just influence our trading decisions, it can affect most of any decision we have made. For example, if I had already started on a course of study, and about 20% through the course I realise that it was the wrong course to take. I might continue with the course and pay for the rest of the course even though it is not what is useful, that is called sunk-cost bias. One good way to mitigate such bias is "Zero Based Thinking". As Brian Tracy describes, you can help yourself by asking “Is there anything in my life that, knowing what I now know, I would not start up again today, if I had to do it over?”. For trading, you can ask yourself "IS there any trade that, knowing what I now know, I would not enter into if I had to do it over?" If there are such trades, and you refuse to take a loss, you know that you are under the influence of sunk-cost bias.

Anchoring Bias (or focalism): Focusing on an anchor rather than market action.
This is what Wiki says: "Anchoring or focalism is a cognitive bias that describes the common human tendency to rely too heavily, or "anchor," on one trait or piece of information when making decisions." My interpretation of this is that if one focuses only on one aspect of trading, instead of the trading system as a whole (You do have a trading system right???) then you have subjected yourself to Anchoring Bias. How to overcome this? I guess... write down your trading plan and stick to it!

Confirmation Bias: The tendency to search for and interpret information that confirms our preconceptions.
I think this is fairly common for many traders. When you take a particular position, say LONG EURUSD, and tend to look for news or price actions that supports that trade, and totally ignore all other indicators or news....

Outcome Bias: Valuing a decision based on its outcome.
This is a good one to remember whenever you make a trade according to your system, but it turns out to be a loss. The book "Fooled by Randomness" touches on this topic, and actually I highly recommend reading that book. Basically, imagine that there was a bet where you had 90% chance of winning $100, and 10% of losing $50. You took that bet and you lost $50. Does that mean that the decision was bad? The expectancy of that bet was positive ($85), so the decision to take it was a good one, regardless of its outcome.

Bandwagon Effect: Believing something because the crowd does.

Loss Aversion Bias: Natural tendency to prefer to avoid loss over acquiring gains.

Disposition Bias: The tendency to lock in gains and let losses run.