Anchoring Bias in Trading. (And you thought you had ‘Free Will’)

Anchoring describes a tendency in our thinking process which leads to us becoming stuck on particular but largely irrelevant reference points which subsequently influences our judgements and decisions. 

Anchoring was highlighted in a famous experiment by Nobel Prize winning behavioural psychologists Daniel Kahneman and Amos Tversky. In the study they asked participants to estimate the percentage of African countries in the United Nations. However before asking the question researchers exposed the respondents to an anchor. They were either asked :

"Is the percentage of African nations that are members of the United Nations more or less than 10%?" 

Or 

"Is the percentage of African nations that are members of the United Nations more or less than 65%?" 

The two numbers 10 and 65 are irrelevant to the question. However those that responded following the 10% anchor guessed on average 25%, and those who had been exposed to the 65% anchor guess on average 45%. The results suggested that the respondents anchored their answer to completely arbitrary numbers presented by the researchers.

How does this affect you as a trader? – One of the effects is to become hooked on your entry level as a reference point, for example let’s say that I enter the market to buy EURUSD FX because I want to go long, I would buy at now at 1.2566, this would now become my reference point, I am likely to be influenced by this number. – This could affect my judgement as I follow the market, obviously it would not be the only factor, however it could sway me towards acting sub-optimally to this trade. –Suppose I place a stop a few points below yesterday’s low at a level of 1.2540, and decide to place a take profit 100 points higher than my entry level. Now assume the EURUSD rallies this over the next couple of hours to 1.2610, then starts to stabilise around 1.2600, I may be tempted to move my stop up to my entry point, thus protecting my profits and avoiding a loss. – This is by all measures a pretty sound strategy, but is it optimal in terms of trading? – My original stop was placed somewhere a bit more relevant, below yesterday’s low point, now it is placed at a level which purely exists because that is where I entered the market where my anchor lies. – Lets also look at some other aspect of the trade, I placed take profit 100 points above my entry at 1.2766, this is another arbitrary number, it relies on the original anchor. It fails to take into account other factors, such as levels of natural support or resistance, pivot levels, trend lines of key moving averages. – It is also possible that sub-consciously this 1.2666 could continue to play an anchoring role throughout the day, influencing my trading judgment sub-consciously. 

Anchoring can affect us and our perceptions of value in all sorts of way in trading, investment and analysis which is not always to our benefit. When key data (E.g. US payroll data) is released on every first Friday of the month the entire market uses the estimates from economists as the anchor for whether the data is good or bad, rather than objectively assessing what this really means for the economy and markets. Too often the original reaction is irrelevant a couple of days later because a more objective assessment of the data has occurred, those traders still holding on to the original anchor can often be trampled over at this stage.

I am sure that we are also vulnerable to being anchored in beliefs which can be heavily influenced by exposure to information, a certain view point, or past experiences, and which can lead to a sub-optimal evaluation of trading prospects. How might this occur, well lets assume you are rather agnostic to rate views in a particular market, however someone hands you a report that suggests rates are likely to rise significantly in the next year, due to factors X, Y and Z. You read it and think you remain agnostic, that you are not bound into any beleif, however now it is quite possible that an anchor has been set in your mind, and future views, beliefs and trades in that market, will be affected by that anchor, rather than a pure objective assessment.  

I will use my own experiences from back in my much younger days to highlight an example: In 1994 I was trading German rate and Bund futures at a large investment bank, through 1994 the bond markets went in meltdown, everything pointed to much higher rates and inflation, it was to prove a very profitable year for me, I was on the right side of much of a very large move. - However the next couple of years proved tortuous, I think that in my mind I had become anchored to the fact that making money came from being short rate futures/long yields. Over the following 2 years the 1994 move was fully reversed, however I was regularly on the wrong side and missed some great trading opportunities.

If anchoring can affect people on an individual level, is it possible that anchoring can also affect the behaviour of the crowd, i.e. many individuals.  It is common for traders to anchor their trading to key high and low points in the market, or previous levels of support or resistance - in my example earlier I place my theoretical stop just below yesterday’s low. These levels can tend to exert an almost gravitational pull on the market, and traders will often place ‘take profits’, ‘stop losses’, exits and entries in relation to these key levels, hence we tend to see volume peak at these key price points (users of ‘Market Profile’ will of course be familiar with this). - It is very common for traders to feel that the market is seeking stops, and many trades become paranoid that the big market-makers and players are teasing with the market, however in terms of anchoring, we can see how much of this is almost a natural phenomenon. 

I come back to the original statement in the title of this post, -‘You thought you had ‘free will’ ’. – ‘Free will’ would imply that you have complete objectivity in your decision making and perception, and complete freedom to make your own choices. – I am afraid to say that sadly that may not be the case. However, familiarity with this behavioural biases, such as anchoring, may start to improve your trading, if you understand the way this affects markets and yourself, perhaps you can start to make small adjustments in your behaviour which can improve your trading performance. 


Image(s): FreeDigitalPhotos.net

Sunk-cost Fallacy : Distorting your objectivity.

 The 'sunk-cost fallacy' is best summed up by the phrase "throwing good money after bad". It is one of those biases which have their root in people’s aversion to losses, and like all these distortions in thinking and judgment, exists just below the level of our consciousness, setting a ‘trading trap’ with the ability to seriously undermine one's performance.

‘Sunk-costs’ are typically unrecoverable costs: In a trading and investment sense they are only unrecoverable when a position is closed out or an investment disposed of. However, this ignores the many other aspects of trading, investment in emotional capital or a particular belief about a market, time invested, cost of running a position (funding/liquidity), and opportunity cost. However, it is often the emotional investment we have put into these which can cause us to avoid closing out/cutting a position.

From a practical perspective how does the ‘Sunk-cost fallacy’ impact traders and investors?

Assume that you own a stock in the belief that it would go significantly higher over a period of a few weeks. Unfortunately, a few weeks later the stock is slightly lower. You have done your homework, you trust your own ability, and all the news since has convinced you more than ever that this is going higher. Thus to back-up your conviction you decide to buy some more. A few more weeks pass and the price is lower again, meanwhile the rest of the market has rallied strongly. At this point on a revaluation basis you are losing money, also you have suffered an opportunity cost against other stocks, you have suffered a time-cost in running the position, and significantly an emotional cost in your ‘emotional capital’ invested in this position and your view. – To close the position now would not only crystallize a loss, but in your mind it would also feel like time, effort and energy totally wasted. – This is where the trap lies, instead of cutting-out, you decide to continue with the position in the hope it will turn around, based purely on how much time, effort and energy you have already put into this for no return or a loss. - What you did however was to base your decision on the effort and resources you have put into the trade, rather than an objective future outlook. Re-stating this another way; your future outlook for this trade is based on what your currently feel about the effort and resources you have put into the trade, and not a clearly thought out perspective of the trade and the market.

As with many behavioural biases, the ‘sunk-cost fallacy’ is really the result of combination of other biases. In all cases ‘loss aversion’ will be a factor, as will the ‘endowment effect’, other factors also affecting individuals could be over-confidence, over-optimism, and 'cognitive dissonance'.

How can one combat the ‘Sunk-cost fallacy’?



This is the tough part; the causes which lead to the beliefs and behaviours which we term behavioural biases are human traits which are part of our make-up, they have helped us thrive as a species, and in many cases helped us at times as individuals. Further to this they typically reside in the sub-conscious and thus are part of our non-conscious decision making and behaviour. Nonetheless, there will be times when they are highly detrimental to our thinking and decision making, particularly in the unnatural environment of the financial markets. Identifying and recognizing when you are succumbing to the pull of biases and irrational and self-defeating behaviours is incredibly difficult,. Traders should however try and develop their ability to be on the lookout for these biases, and an aptitude for reflection and introspection is an extremely useful tool to develop. Keeping a trading journal or diary is one step you could take to help you hone this ability. Traders should also try to question their actions thus allowing a more objective assessment. Discipline and planning are of course great allies; had the investor, in the above example, written out a plan pre-committing to a certain course of action and with various what-if scenarios, he may have had a rough blueprint to guide his actions and thinking. Finally a rule base or at minimum guidelines can keep you out of trouble, this is always a slight conundrum for traders and investors, because too much rigidity stifles creativity and intuition, however good traders develop a sense of when to act in a certain way and when to adhere to their rules/guidelines.

Trader Biases

I posted an article yesterday about a particular trading bias known as 'the Endowment effect', this article is one of a series of articles on trader and investor biases that I have written about in recent months. Traders and Investors are affected by a wide range of behavioural biases caused by an array of psychological, philosophical, physiological and sociological factors. These biases, though often subtle, can seriously distort one’s thinking processes and limit their ability to think and act as rationally when it comes to making trading judgments and decisions.

The list of biases which I have written about can be seen below, to view each article just click on the bias.

Loss aversion (Feeling and fearing losses more than the pleasure derived from making and anticipating equivalent gains).

Ambiguity Aversion Bias (Fear of uncertainty or the unknown).

Cognitive Dissonance  (The discomfort caused by simultaneously holding conflicting cognitions (thoughts, ideas, beliefs, values, emotional reactions).

Recency Bias (A tendency to value the outcomes of recent trades over the outcomes of less recent trades).

Confirmation Bias (Seeking views and opinions which confirm one’s beliefs).

Attribution (Self-serving bias) (Accepting the credit for favourable outcomes, whilst blaming unfavourable outcomes on other factors).

Endowment effect (Valuing something more when we own it, than when we do not own it).

This list can also be seen on the tab at the top of this page. As I post new articles, so I will update this list.

The Endowment Effect - Messing with your sense of value.

The Endowment Effect – Messing with your mind.

Consider the following scenario: You have the option to buy a particular stock, which you are told by a reliable source may increase in value 20% at some point in the next month, the source can not tell you why, but you trust this source. You decide to invest some cash that you have lying around not earning much interest, say $10,000 in this stock at $1.00 per share. Over the next few weeks not much happens and your source then  informs you that his expectation did not materialise.

Assuming you can sell the shares for $1.00 and therefore suffer no loss (Ignoring any brokerage fees). – What would you do?

A). Do you just sell the shares? Let’s face it; you never had much interest in that company in the first place.

Or

B) Do you hold on to them? Now that you own them perhaps they are a good company after all, they may not have had the big rise that was predicted, but they may still turnout to be good value.   

So what do you do?

In reality it should be a no brainer. – Prior to the recommendation, you had no interest in owning the shares; you bought them for one reason only, because you thought there was going to be a quick buck to be had. Thus the rational thing to do would be to go back to putting your money into cash until a good investment opportunity comes along. However, there is a chance that in reality you select option B; now that you own the shares you personally attach a higher value to them, and would rather wait for someone to pay you a higher price for you to sell them. This of course is a highly irrational way to think, but unfortunately as humans we have a tendency to be swayed from acting in a rational way at times, and it should be no surprise that many of those times are when money is involved. It is not truly known why we are prone to act in irrational ways at times, however it is known that this irrational decision making part of the brain lurks just below the level of our consciousness, acting silently to hijack our rational thoughts and causing us to see and perceive the world in ways which are not always beneficial to us.

In the above example, choosing option B would be an example of a pattern of behaviour termed ‘The endowment effect’ by one of the godfathers of ‘Behavioural Finance’ Richard Thaler. Thaler had identified that people were willing to demand more to give up an object that they owned, than they would be willing to pay to acquire it.  The endowment effect can be seen at work all day and everyday in trading and investing, as well as in many other aspects of our life. Let’s look at a theoretical example taken from day-trading.

Two traders – Trader A and Trader B are day-traders in the FX market,

The following chart shows a particular day’s trading action in Spot EURUSD FX.

The entire day’s trading, until the late afternoon, has been bouncing within in a range between the high 1.3130s and the mid 1.3170s. Both traders decide to execute a long position in the late afternoon on the approach to the low of the range at 1.3140. For a short while the EURUSD starts moving higher, but the move soon fades away, and the currency pair starts to decline and breaks down through the low of the range. - Both traders typically take the same approach to trading; however trader A sticks to the method religiously and is rarely distracted from it, whereas trader B is prone to being side-tracked. – Normal application of their method would see them cutting out the long position on a break below the days range, and going short. This is the action Trader A carries out, which results in a profit of 28 ticks over the course of the trades. However Trader B had allowed himself to be compromised by succumbing to the endowment effect. - Thus when he was went long of the EURUSD FX spot in the afternoon, he adopted a belief that it should have a higher value, when it broke the support level, which would signal that he should be abandoning the position and going the other way, he maintained this belief and not only held on to the position, he also decided to buy more, in this case he doubled the size of the position. – By the end of the day, in accordance with the trading rules of his firm, he had to be out of all positions; thus he had to sell the position out pretty close to the low of the day ultimately resulting in a loss of 74 ticks over the course of the trade.

Whilst this is a hypothetical example it is representative of what happens in many real situations, across many markets and across all time-frames.

Going back to the EURUSD example, the close of the day’s trading should ensure that Trader B’s worries are over. However the danger may not necessarily be over for Trader B, having gone home and possibly dwelt on the events of the afternoon, he may well be feeling a touch aggrieved and angry. He may be asking himself, why the hell he was caught holding onto the long position and doubling up rather than following the normal rules. At this point a new danger is getting ready to present itself: - Readers of some of my other articles on biases may be familiar with the bias of ‘cognitive dissonance’, they also may also have heard me mention how one of the dangers of decision/judgement biases, is that one sometimes they can lead to a string of damaging and dangerous decisions and judgements.

Getting back to this example, what we may have is a ‘cognitive dissonance’ at play here. In this case the dissonance is this; on the one hand Trader B believes that he is a good smart intelligent trader who knows what he is doing, and on the other hand he did something stupid and foolish. Accepting our own foolishness and fallibility is not a comfortable thing for many people; hence in this case Trader B chooses to resolve the dissonance by believing that the right course of action was to go long he was just unlucky, and that next time in the same situation he would do the same thing. Hence dissonance is resolved by an ‘erroneous self-justification’, and subsequently Trader B gets a good night’s sleep. - What this means however, is that the next time he is faced with a similar situation he may follow a similar course of action to that he took above, he may get lucky next time and it turns out right, but he will no longer be following his system or method which has proven successful in the past, and eventually this could turn out to be the first stages of a long period of under-performance. 

The endowment effect can have repercussions in many ways some of these are as follows:

• It can cause traders to hold on to trades too long, eventually giving back most or all of a profit.
• Traders may not cut, or even increase losing positions.
• Traders can suffer from distortions in perceptions, leading to them not objectively assessing incoming news or data.
• A trader or investor may develop an ‘entrenched view’ which causes them to make poor decisions and choices and to fore-go opportunities elsewhere.

Identifying and recognizing when traders succumb to the pull of biases and other irrational and self-defeating behaviours is incredibly difficult, as I mentioned earlier, they tend to sit just below our level of consciousness. Nonetheless traders should be on the lookout for these behaviours, and there are certain courses of action you can undertake to help identify when we are falling victim to them, and to then try and focus our attention in order to reduce our vulnerability to these behaviours.

One step I always advocate is keeping a trader's journal of one's actions, behaviours, thoughts and feelings around their trading. As part of the journal process one should be reviewing their actions and double-checking their thinking and reasoning.

Trader's should also try to to question their actions; are they in a trade for the right reason? are they thinking rationally? If they are in were not in the trade they are in, would they get into it now? If they feel uneasy about a trade, look back to the original rationale for the trade, and crucially try and distance themselves a little from the trade, thus allowing a more objective assessment.

Discipline and planning are crucial; in the first example had the investor written out a plan pre-committing to sell if the share price fails to rally as expected  he may be more likely to take option A, the rational course of action. In the second example, if Trader B had remained disciplined and focused he would have booked a profit instead of a significant loss, and would not have been thrown off-course on his trading plan.

To see and learn more about the psychological and behavioural aspects of trading, including further information on biases and irrational trading behaviour, follow the link to the 'Trader,Trading & Risk Psychology' website.

‘Recency Bias’ can distort our decision making and judgmental processes, thus reducing their effectiveness.

Recency bias is the tendency for traders and investors to give a greater weight to more recent trade performance, news and information, rather than taking into account older news, information and performance. This leads to distorted perceptions, decisions and judgments, and as such can seriously undermine overall performance sometimes with very negative results.

Here is a simplified example:

A trading method or system involves taking hundreds of trades per year. The hit rate is distributed fairly evenly, with more wins than losses, but with wins typically being three times the size of the average loss.

For example a typical run would look like this:

Win, Loss, Loss, Loss, Win, Loss, Loss, Loss, Loss, Win, Loss, Loss, Loss, Win, Loss, Loss, Win, Loss, Loss, Loss. 

(In summary 15 Losses, and 5 Wins: With wins performing three times better than losses the net effect is zero.)

Now compare it to this run:

Win, Win, Win, Win, Loss, Loss, Win, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss, Loss.

(In summary 15 Losses, and 5 Wins: With wins also performing three times better than losses, thus again the net effect is zero.)

Whilst the outcomes of the two run of trades are different, the trader may feel differently about his system or method at the end of the second run. The last 10 trades on the second run were all losses, whereas on the first run there were 3 wins out of 10, thus a fairly even distribution. Whilst this example is quite small the effect may nonetheless make the trader start to question his system or method: Is it still valid? Have the rules changed so much that he should alter the (proven) system or method? Should the trader take the next trade? Should the trader lower the risk level on his next trade? – I hope you can see where I am going on this.

In Curtis Faith’s excellent book, ‘The Way of the Turtle’, there is a great example of this: Faith provides a friend, who has begged him to reveal the secrets of his highly successful trading system, with all the details of the system. However the friend rather unfortunately decides to override the system following a string of losses. The relevant paragraph from the book is as follows:

‘Around February 1999 I (Faith) asked him how he was doing in cocoa since I had noticed that there was a great downward trend. He told me that he did not take the trade because he had lost so much trading cocoa and thought that the trade was too risky’. Curtis noted that prior to the downtrend starting there was a run of 17 losing trades. Collectively these losing trades added up to a loss of nearly $17,000. The subsequent 11 trades, which the trader did not take, contained 4 winning trades and 7 losing trades. The net result of these 11 trades was a profit of around $73,000.

It is worth noting that this ‘recency bias’, also occurs in the way we make many judgments, process information and review news. Investors may shun a share because its recent dividends were poor; however behind the scene the company may have made a significant investment in restructuring and producing new lines which will yield significant future results.

Another effect of recency bias is to alter our state of mind. There is nothing worse than a string of losses to dampen our enthusiasm. It may be that at this point we start to question ourselves and our ability, and that opens the door for self-doubt. Once self-doubt creeps in then we could fall into a viscous circle of doubt and crisis of confidence; we then start expecting poor outcomes, and once this starts happening we then actually then create them.

I would also like to add that though these examples focus on negative recency bias effects. However positive recency bias effects can also throw us out. – In the earlier example, a string of recent wins could have caused the opposite effect, making the trader less cautious and far too overconfident, thus leading them to take too much risk, with eventual disastrous consequences.

So what is happening for us to be affected by recency bias? – Well to one degree this is a natural occurrence, in the real world, recent events are much easier to recall. Our working memory, which is part of our conscious mind used for learning new activities, it has only limited resources, and as such is only able to hold a limited number of ideas and memories at any one time. As such older memories get put to the back of our mind, into our long-term memory: Whilst the storage in long-term memory is infinite, the ability to accurately recall this information and to have it at hand is difficult. Thus we have a much clearer recollection of recent events, and as such we end up with a distorted view of reality.

So what should one do to avoid the effects of ‘recency bias’?

1) Awareness of the problem is always the first step. – But rather like recency bias it-self, any memory you have of this article you are reading now is likely to be lost into your long-term memory before long, and will not easily be recalled. I would suggest make a note of this and other biases (Preferably in a journal), reminding your-self of how it may affect your trading and judgement. – It is essential to re-visit this periodically to remind yourself with regard to this and other biases and how they may affect your judgement.

2) Try and ‘develop a habit’ of tracking the record of your trades, or other relevant data you may be watching. – Here again a journal is highly valuable. – When you do hit an extended run of data or news, try and look back at it in perspective of the bigger picture.

3) Set-up rules, guidelines and criteria for trading and analysis. Check yourself regularly to ensure you are abiding by these criteria. Once again, our old friend the journal is an excellent place to note these rules, guidelines and criteria.

4)) Manage your-self: The more stressed and anxious one is, the more one is likely to veer from common-sense, and good practice. Euphoria, over-confidence, despair, self-doubt, and many other stated all have the ability to throw us off course, and lead us to abandon our usual work mode. Try and make obtaining and maintaining balance and perspective part of who you are and how you work. – Once again maintaining and reviewing a journal is an excellent tool to use as part of this process, along with a healthy life-style, exercise, work/home/social balance, etc.

We are as humans all prone to recency bias, however as traders, we have to ensure that somehow we do not let this affect our ability to perform and make sensible decisions and judgments.