Trading Biases - Ambiguity Aversion - Loss aversion's companion,

Ambiguity aversion is an aversion to uncertainty. This is a tendency to favour a known risk over and unknown risk, or security over insecurity, and quite frankly, who wouldn't. This attitude is central to much of what we do and how we behave, it is written into the fabric of our lives in so many ways, think of the many phrases and sayings which have become a major part of our language; 'better to be safe than sorry', 'a bird in the hand is better than two in the bush', 'better the devil you know, than the devil you don't', and so forth.

People generally hate uncertainty, though as with all personal characteristics, the aversion to uncertainty varies from person to person. - The higher value a person places on certainty and security, in relation to other values, the more likely they will be affected by ambiguity aversion.

How does this manifest itself in trading: One of the side affects is that people are unwilling to stay with risks. I have often seen traders take small profits on potentially winning trades in order to reduce uncertainty in outcomes, only to regret this later (I include myself at this, and often come to regret it). Ambiguity aversion is also a major cause of cutting trades preemptively rather than awaiting a predefined stop to be hit (Hello - another guilty trait). - I have also seen traders close positions just because the suspense was killing them, even though the trade had neither made a significant profit nor a major loss.

Together with loss aversion, 'ambiguity aversion' is one of the major causes of trader under-performance. - It is easy to understand why we possess these characteristics; in the natural world, where we have spent millions of years evolving, taking risks with uncertain outcomes could have been fatal. It was far safer to eat the berries of trees one would be familiar with than eat the berries and fruits of trees we do not know. That very attitude was a sensible and safe option and has become hard-wired into our thinking. However, that very same thinking in the financial markets has the ability to seriously derail a trading strategy; there is a price to pay for reducing uncertainty (loss of potential gains and cost of insurance).

Many of the most successful traders have developed strategies which work in their favour and against loss aversion; they have found ways to overcome this natural tendency. If one is to take their trading forward, this is one of the hurdles one must face and overcome.