Optimism Bias: It can seriously affect your judgment and trading performance.

Optimism Bias: Is a natural human bias that causes a person to believe that they are less at risk of experiencing a negative event compared to others, or that they are more likely to succeed or be good at something than reality would suggest.

Firstly let me stress, ‘Optimism is good’, most successful traders I work with, as a coach, are typically optimistic, they believe they can beat the market and often do. However they are also self-aware and have a high degree of humbleness (Which tends to run contra to the popular image presented in modern day culture). As an ex-professional trader, I actually think we need a degree of optimism to switch on the screens and start trading every day. We need optimism to return to the fray after the market has given us a severe beating, and we need optimism to balance the natural fears we have which can cause us to panic out of certain trades or which lead to other poor decisions.

However, over-optimism, as emphasized by the optimism bias, can be extremely damaging: It forces people to take trades the should they never should engage in, warping their view of reality, and damaging their objectivity. All of which culminates in a state of ‘unrealistic optimism’! This matters, it matters a lot! As a consequence, people’s decision-making and judgment become heavily impaired, causing them to over-estimate the possibility of favourable outcomes, and under-estimate the likelihood that trades will fail. Ultimately their risk-reward is going to be skewed, perhaps quite heavily. Whether you are an investor or trader, and whether your approach is fundamentalist, technical or quant, whichever method is your poison, you need to have an edge, and that edge is the mathematical outcome of your risk/reward ratio.

This excellent and entertaining TED talk by Tali Sharot talks about the ‘Optimism Bias’ will illuminate you further on the ‘Over-optimism’ bias. 

What can you do to help you over-come the effects of ‘Optimism Bias’ in your trading? Firstly, I would say that you are unlikely to alter your actual ‘optimism bias’, it may vary in certain people and situations, but all people have it. Rather like your shadow, it will always be there, it is a part of you that evolution has welded into your psyche, and that acts in way to impact your perceptions and decisions just below the level of consciousness.

Nonetheless, there are certain ways you can behave or act to try and counter its effects.

1) Raising Awareness is a first step. Hopefully articles such as these are part of raising your awareness of ‘Optimism Bias’, though no doubt within a few days, if not hours of reading this, your memory and conscious awareness of ‘Optimism Bias’ is likely to fade. However a seed will hopefully have been planted that can be nourished through further reading of the human behavioural aspects of decision-making and other memory-stirring practices.

2) Creating a more structured way of trade selection, trade management, and risk-management should help combat optimism-bias. A more structured approach does not have to be too rigid and heavily rule based, by doing so I believe can harm your adaptability and creativity. However by developing certain rules or guidelines and trying to adhere to them, you should create a stronger discipline and allow yourself to create more control over the sub-conscious forces which can derail your trading.

3) Use a Trade Journal or Diary (Either written or electronic). This has many benefits, including:

• ­Supporting a more structured approach as discussed above.
• ­Allowing one to plan their trades more effectively, therefore creating greater objectivity.
• ­Reminding the person of the initial reason and rationale for the trade, and therefore helping to remain on track.
• ­But in this context, I like a trade journal as a ‘Behavioural Awareness’ tool: Let me explain: If you record many of your trading decisions you can then periodically look-back and review your decisions and actions. We rarely learn from our mistakes, because we tend to shut our minds to them. This is part of ‘Optimism Bias’, we don’t want to recall our stupidity or poor-trading as it damages our self-belief, therefore we often banish them from our memory thus allowing us to foster the ‘self-belief’ which is necessary for trading success. Unfortunately, the downside of this is that it also feeds one’s ‘Optimism Bias’. However, by recording reasons for our decisions, and the actions that followed, even just with a few words, (I prefer keeping journals simple: ‘Less is More’), then we can return to them in the future. By reviewing our journals through time, we can raise our awareness of our actions. I use to do this during my trading days and shocked myself when I realised some of the behavioural patterns and mistakes I was repeating. ‘If we are not aware of them, we can’t even start to address them’.

4) There are many other actions we can take to fight the ‘Optimism Bias’, such as seeking alternative opinions, looking at trades from alternative perspectives, active use of Stops/Trailing Stops etc. This is all part of the toolbox one develops during their trading experiences.

On the other hand, you have to ensure that you don’t extinguish your self-belief, it is important to remain optimistic in the face of the many challenges and hurdles that trading throws up. But one should always strive for greater realism and objectivity whilst trying to balance all these various divergent and opposing forces and finding a way which provides a clear edge to one’s trading.

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The 'Behavioural Trading' blog is written and managed by leading Trading Performance and Behavioural Trading Coach Steven Goldstein. Steven is Managing Director at Alpha R Cubed, who work with banks, hedge funds and investment firms to help them improve their people's capabilities within their frontline financial risk businesses. To know more about Alpha R Cubed, visit the website www.alpharcubed.com or email Steven at steven.goldstein@alpharcubed.com. Follow Steven directly on Twitter.