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.  

Trading Biases - Loss Aversion - The Biggie.

One of the most common mistakes we all make as traders is to think that we really have 'free-will'. There is a saying which is often quoted by traders - 'You pays your money, you takes your choice'. - The underlying message being that we are totally in charge of our own choices and essentially we have free-will when it comes to decision making. Having been a trader for 25 years, and now as a trading coach, I actually think that this is a dangerous illusion which derails many if not most traders. At the core of this is the belief that traders are affected by a wide range of psychological, philosophical, physiological and sociological affects which influence their ability to think and act rationally when it comes to making their trading decisions.

All people suffer from natural biases and traits. These biases and traits have evolved over millions of years, they are part of our natural make-up and have aided our survival and have helped us thrive in the natural environment. - A few thousand years of domestication versus millions of years of evolution have however not been enough for us to lose these biases and traits which are really our basic instincts. In the trading environment many of these 'basis instincts' can severely impair our ability to read the markets objectively and make good trading decisions. - The first step I implore traders to take in order to help mitigate the destructive affect of biases on their trading is to try and understand these biases, and to become fully aware of them. Below, is a description of what I believe is the main destructive bias to impact one's trading. 

LOSS AVERSION BIAS.
Over the past couple of decades the fields of behavioural economics and finance have shed a huge light on the way we as humans make our decisions in relation to financial matters. Probably the most significant advance in that time was work by Amos Tversky and Daniel Kahneman on 'Prospect Theory' for which Kahneman was awarded the Nobel Prize in Economics in 2002. One of the central elements of this was 'Loss Aversion' bias, which states that people have a psychological tendency to handle equivalent gains and losses differently; a loss almost always feels more painful or detrimental than an equivalent gain.

An example of this would be the pain that losing an amount (say $50) is worse than the equivalent joy from gaining an equivalent amount. This bias manifests itself in all sorts of ways in trading and investing. - Often when a trade starts losing money, there is a tendency for traders to hold on in the hope that the trade will recoup its losses, rather than cutting the losing trade early. In many cases the trade continues losing money, and the trader is faced with much larger losses. This is exasperated by many traders only taking a very small profit (or even cutting out flat) on the occasions the trades do come back. -- This creates a dangerously asymmetric risk/return profile. 

There has been much research into the 'Loss Aversion' bias: In one study it was found that people tend to view losses as having around 2.5 times as much negative impact as a gain of a similar magnitude. In other words a $100 loss has an equivalent impact (in negative terms) as a $250 gain (in positive terms). There is an old trading adage that traders 'should run their profits and cut their losses', often however traders tend to do the opposite, they act in a way that is psychologically comforting to them, but is actually detrimental to their performance. In my early days, quite some years ago, I was told by other traders 'that no one went broke taking a profit', if ever there was poor advice, then that was it! - I have seen far too many people go broke over the years because they took small profits and ran their losses. Though it was only occasionally that those losses would seriously deteriorate, when they did happen they would run and run, and it only has to happen once or twice to completely ruin someone.

Awareness of our tendency towards 'Loss Aversion' is a starting point, though on its own awareness is not going to help overcome the tendency. Traders have to ensure that their strategy and approach to trading is correct and able to offset this as well as many other all destructive biases. - I will talk about this in future articles, however it worth noting what successful traders tend to say around the subject of 'Loss aversion'. Veteran trader and hedge fund manager Peter Lynch is quoted as saying: 'Some stocks go up 20-30 percent and they get rid of it and they hold onto the dogs. And it's sort of like watering the weeds and cutting out the flowers. You want to let the winners run.'

Confirmation Bias - A pernicious threat to your own trading.

Do you recoil in anger at a news story, item, article or blog that differs strongly in opinion to your market view or position?

Do you perhaps find that when a blog has an opposing outlook to you on the market, you stop visiting it?

If the headline to an article is the complete opposite of what you think, do you blatantly disagree with it, even without reading it?

These are all signs of ‘confirmation bias’; a bias which poses a serious risk to your trading success.

When traders have a view, hypothesis or opinion about market direction, there is a danger this can become deeply entrenched. The placing of trades and strategies concurrent with this view deepens this attachment, as do mixing and sharing this view or opinion, with other like-minded individuals. The discussions will veer towards confirming with each other how right you are, and any opposing views opinions will be quickly dismissed. Typically then what happens you pick up on evidence that supports your hypothesis and ruthlessly ignore or dismiss any evidence that opposes it, even without giving it due consideration, often without even reading it or listening to it.

Over the years I have seen the 'confirmation bias' literally destroy traders. I myself have been victim to it, though thankfully without disastrous consequences and before it became too entrenched. I think humans probably have a natural tendency towards it, perhaps linked to a deep-rooted behavioural trait or habit that is natural to us in some form and which served its purpose in ensuring our survival when we roamed the ancient open plains, savannahs and jungles.

My own way of dealing with it, or overcoming it, was to be rigorous and thorough with my analysis and research. I would make sure I tried to visit, read and listen to opposing views. On many occasions, where I had a strong technical analysis opinion, or had seen some research or data which lead me in one direction, I would seek to disprove it, deliberately looking for flaws in my arguments or conclusions (sometimes the market would do the work for you). - As these flaws or holes would disappear or not stand up, my conviction would grow that I was on the right path, though I would always try and keep an open mind. - Even then I was still prone to lapses, but I think you have accept that it important to try and strike a balance between having a degree of self-belief and conviction and questioning that belief, otherwise you risk ending up with no view and never taking a risk.

It would be interesting to hear other people's opinions, thoughts and experiences on this.