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

‘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.

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.