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.

Change of Title Once again.

This blog is going through yet another change of title. 'Mindset of a Trader' has now gone the way of 'Hometrader UK'.

I have chosen the new title to match my Linked in Group which has grown and developed rapidly over recent months. - The Group 'Trader, Trading & Risk Psychology' attracted over 1100 new members in the 6 months to the end of last year.  - Please fill free to join the group. -  The link is http://www.linkedin.com/groups/Trader-Trading-Risk-Psychology-3863963?gid=3863963&trk=hb_side_g

The aim of the group is to be a forum for thoughts, reflections, opinions, views, and discussions on matters related to trader/investor and risk psychology, behaviour and philosophy.

This includes:
•    Trader & Market Psychology.
•    Trader Performance & Development.
•    Behavioural Finance related to Trading.
•    The Psychology of Risk.
•    The Psychology behind Technical Analysis.
•    The Philosophical aspects of risk and trading.

Any other subject within the context of trading psychology.

I do ask group members to refrain from posting direct promotional material to the group discussions, instead please post these to promotions. Please however feel free to use membership of the group to benefit your business or field of interests in other ways:

• It could provide an opportunity to pose a question and receive feedback and opinions from experts and peers.
• Find networking opportunities with peers and cohorts from your business, profession, or field of academia.
• Share your ideas and knowledge on appropriate subjects with like-minded people.
• Discover new leads and information which could be of benefit to your business, job, or academic research.
I do also ask members to keep discussions within the broad context of Trader, Trading & Risk Psychology.

I encourage members to share ideas, post questions, raise discussions and so forth in accordance with the aims of the group.

As owner of this group I would like to maintain the integrity of the group to achieve the above aims. Thus I will endeavor to keep the group clean and free of spam, inappropriate posting, or postings not in accordance with the aim of the group.

If anyone feels a question or issue raised is left unanswered, please feel free to send me a message, and I will what I can to provide an answer or solicit responses from the group.

Warm regards

Steven Goldstein

Please also note there is also a 'Trader, Trading & Risk Psychology' website, which I am building up to become a compendium of knowledge and information on trader psychology. - This is still in the early stages of development, however feel free to check it out at http://www.mindsetofatrader.com/ (At some point soon the address will change to reflect the correct name. )

Cognitive Dissonance: Where traders start to dig holes for themselves.

‘Cognitive Dissonance’ is a theory which states that we like to seek consistency in our beliefs within our mind. If we hold two conflicting or opposing beliefs we get a feeling of discomfort or unease, as such we attempt to reduce this dissonance in our minds caused by holding these two conflicting beliefs. This dissonance reduction may involve us self-justifying or deceiving ourselves, this includes acquiring or inventing rationales which resolve this internal conflict, or modifying previous held beliefs.

As mentioned, dissonance reduction often takes the form of a self-justification of self-deception. Some examples of this occur all around us, smokers typically display cognitive dissonance, they know it is bad for them, and that it will probably shorten their life, but they’ll reduce the dissonance and justify the smoking by thinking ‘It’s not really as bad as they say otherwise it would be illegal’ or ‘I’ll worry about that when I’m older’, etc.  Dieters will also fall victim to this, they may justify having a chocolate or piece of cake by thinking ‘Its just one, what harm can that do?’ Last year in the UK there was a major scandal involving expenses fraud by Members of Parliament, whilst passing anti-fraud legislation, they had no issue with this contradiction, claiming their expenses were entitlements. Police will often continue to prosecute suspects whilst wilfully ignoring contradicting evidence. Academics have been known to doctor research evidence to suit their arguments, explaining this away by firmly stating their conviction in their beliefs.

Cognitive dissonance is all around us, and is often intertwined with other biases and behavioural traits. In a sense procrastination is only achievable because we enact dissonance reduction. E.g. ‘I’ll do that piece of work later, after all what’s the rush’.

So what and how does these affect traders and investors directly?

I’ll provide some simple examples.

Firstly, assume I have a long position in the SP500 Index future, say I bought some contracts at 1250. I then placed a protective stop at 1240 whilst looking for an upside target at 1280. I have a personal trading rule that I never move a stop further away once it is in place. – Later that day, the SP500 is trading down towards 1242, I sense that my stop is too tight and that this will bounce. I have a cognitive dissonance, my original belief was that if the market traded down to 1240, I was out of this trade, I was not prepared to risk any more on this trade, based off my initial analysis. Now I am thinking that this may trade lower and then bounce, however I will be stopped out before then. My dissonance here is that I need to remove my stop and place it at a lower level, but I never move stops once in place, this is a ‘golden trading rule’ for me. However, I decide in this case that I can break the rule on this one occasion, my though process is ‘just once it won’t hurt, I have a really good feeling about this’.

Hence I move the stop to 1230. The best thing that could happen in this case, is to get stopped out at 1230 immediately, as I would have instantly been penalised, and should thus learn the error of my ways. But assume that instead the SP500 drops to 1235, the stop is not triggered, and the SP500 bounces and rallies to my target. – I will feel that I was justified in moving my stop, and hence will be almost certainly giving me the green light to repeat that. Thus now a sensible rule, put in place as a form of discipline is jettisoned, and a slippery slope has been started, almost certainly with disastrous future consequences for my trading.

Another trading example shows how self-deceit rather than self-justification can be the dissonance reduction technique. In this example, assume that a trader was playing the USDJPY carry trade in 2007, and had decided to go long USDJPY on a break over 121, convinced that this was heading higher to 132 and maybe higher. His conviction is built on that the fact that this has been trending higher 2 years, is buoyed by the fact that he is gaining nearly 5% yield pickup on a daily basis, and is boosted by the knowledge that just about every major player is in on this trade. - Briefly the USDJPY rallies to 124, he is making money and feels good, all the stars seem in line, and in his head he is thinking of the future rewards this will bring. But from 124 the USDJPY declines and breaks a key level at 118. Now he is sitting on a loss, and looking at analysis which is indicating a major reversal is underway.

The problem for the trader, in this example, is that he has attached himself to this position; he had in a sense bonded and indentified with it. His evidence firmly suggested that a deeper reversal is underway, but he decides to label this a minor correction. This new analysis had created a cognitive dissonance for him; he resolved the dissonance by trivialising his normal rational analysis and invoking a self-deception; he decided that ‘this time it was different’. (There are a couple of other cognitive biases at play here, - The endowment effect; valuing an asset more highly when we own it, and the previously discussed confirmation bias). Eventually this trade would have suffered a huge loss, USDJPY declined sharply to below 100.   

The problem with ‘dissonance reduction’ techniques is the use of ‘justifying terms’ – such as ‘just once’, or ‘this time its different. Of course we never do something ‘just once’, in fact usually when we break a rule, we tend to repeat breaking it, particularly if we’ve justified it and been proved right on that occasion.

In the Carol Tavris and Elliot Aronson excellent book, ‘Mistakes were made (but not by me)’, they talk about how this process takes hold in the creation of corrupt police practices. A good young highly principled cop sees an older cop plant some evidence. He is angry, confused and conflicted, but the older cop says to him ‘We’re the good guys, these criminals are getting away with crimes that we know they are committing, isn’t it better that when we know something and can not prove it, we make it provable, its not like we do this regularly, but in this case its different, it’s a one-off.’  The young policeman decides to look the other way on this occasion, just once. – A couple of years later, this happens again, but having already justified it previously he convinces himself of the value of this. Eventually some years later, without a hint of conscience, he is repeating this behaviour himself. – He may not necessarily be a corrupt cop, he may be a good cop who has adopted some bad practices, but either way it is quite likely that innocent people are going to prison somewhere, and guilty people are out running free.

Cognitive dissonance can be the loose thread, which slowly pulled over time ends up destroying a whole fabric. In a trading/investing sense this is often what can happen; a sensible reliable trading approach can start to come undone, and as in the first example above, it is not the initial action, but rather what it implies, where the problem often starts. In the second example, the self-deceit can lead to a warped view of the market. From my own experiences working with traders, cognitive dissonance can lead to traders digging themselves deeper and deeper holes and by the time they realise what has happened it may be too late.

‘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.

Understanding our natural and developed human tendencies can help improve trading performance

One of the most common mistakes we all make as traders and investors 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. Having been a trader for 25 years, and now as a trading coach, I believe that is a dangerous illusion which derails many if not most traders and investors. At the core of this is my belief that traders and investors are affected by a wide range of psychological, philosophical, physiological and sociological affects which affects and limits their ability to think and act rationally when it comes to making their trading decisions.

All people suffer from natural and learned biases, traits and habits, which for the sake of this article I collectively term as tendencies. Many of these tendencies 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 not been enough for us to lose these natural tendencies which are really our basic instincts. We also pick-up many tendencies as we grow and develop, these are shaped by our environment, our education, our upbringing, social factors, culture and belief systems, and help to instill certain ways of thinking.

These tendencies are either part of our natural make-up or have been influenced and shaped as we have grown and developed. They enable us to make decisions quickly and reasonably, they have helped us to learn and develop, and to fit in and adapt. As a result of these we are able to filter information quickly, to learn rapidly, and to move forward in the complex world we live in. However as a result we also do not truly receive and recall information in an objective sense, but colour it in any number of ways in order to match our preferences. Thus often we 'see what we want to see' and 'hear what we want to hear', we make decisions which are comfortable for us, that help to reduce anxiety and keeping us feeling safe and secure.

In the natural world we evolved in over millions of years, and in the social world we grow up into, these tendencies are often perfectly rational and beneficial. However in the somewhat unnatural world of the financial markets, these same tendencies can sway people's (traders and investors) decisions, choices, and behaviours in unfavourable directions. As a consequence traders and investors often display limits to their rationality, lack the necessary self-control required, and will become heavily influenced by social factors and their environment.

In the world of trading and investing there tendencies often lead traders and investors astray, sending them on false paths, and exposing them to 'decision traps'. I believe that increasing knowledge and understanding of these behavioural tendencies could make an invaluable contribution towards improving traders and investors’ self-awareness and increasing their knowledge base of themselves, others, and markets in general. Elimination of these tendencies is not a realistic goal; one cannot fight basic human nature and expect to win. However, by deepening one's understanding of who they are and how they work, one can provide important information which can help them modify their behaviours and strategies, in order to pursue a more optimal approach towards trading. 

Many of the world’s most successful traders incorporate strategies into their trading and their approach to trading, which have helped them, overcome these natural tendencies. By following these successful strategies they get closer to exercising free-will in their trading, free-will to choose a trade, free-will to execute entry and exit, free-will to correctly exercise appropriate risk and money management, free-will in being able to objectively analyze data, news and information.