FROM THE ARCHIVES: Don’t Believe Everything You Think

Here’s a great review of the common human weaknesses we have to contend with as traders.

I have become fascinated with the subject of cognitive bias.  Wikipedia describes cognitive bias as:

cognitive bias is the human tendency to draw incorrect conclusions in certain circumstances based on cognitive factors rather than evidence. Such biases are thought to be a form of “cognitive shortcut”, often based upon rules of thumb, and include errors in statistical judgment, social attribution, and memory. Cognitive biases are a common outcome of human thought, and often drastically skew the reliability of anecdotal and legal evidence. It is a phenomenon studied in cognitive science and social psychology.

I feel that cognitive bias plays a huge role in the inefficiencies of financial markets and the repeated mistakes of everyone from professional traders to rookie investors.  There are four types of bias: Social Bias, Memory Bias, Decision Making Bias, and Probability/Belief Bias.  From what I have read there are at least 100 distinct biases that exist.  I will examine the ones that I feel are most applicable to trading.

  • Herd instinct – The common tendency to adopt the opinions and follow the behaviour of the majority to feel safer and avoid conflict. There is an illusion of safety in numbers and if other people are doing it it can’t be that bad.  There is also the shared comfort in knowing that if the trade goes badly, “We’re all in this together.”  This is a terrible way to think, especially in trading.  Herd instinct can also lead to speculative bubbles.
  • Trait Ascription Bias – The tendency for people to view themselves as relatively variable in terms of personality, behaviour and mood while viewing others to be more predictable. I see this all the time and often catch myself on this one.  Anytime you hear an analyst or pundit on TV talking about where ‘Mutual Funds’ are allocating capital or what ‘Hedge Funds’ are doing they are assuming the person or group that they are talking about is somehow more predictable than they are.  ”Mutual fund managers have already allocated their capital, there’s no way this market can go any higher!”  Bullshit.
  • Rosy Retrospection – The tendency to rate past events more positively than they had when the event actually occurred. When you remember a blow-up you rarely remember the visceral emotional details of the event.  All you remember is that you survived and, eh, it wasn’t so bad.  This is also a survival mechanism.
  • Hindsight Bias – Filtering memories of past events through present knowledge so that those events look more predictable than they actually were.  This one is obvious and probably one of the most common.  Each event is unique.
  • Negativity Bias – Phenomenon by which humans pay more attention and give more weight to negative than positive experiences or other information.  This is probably one of the reasons that Bears tend to skew towards apocalyptic (End of Fiat currency, stock up on grains and guns).
  • Normalcy Bias – The refusal to plan for, or react to, a disaster which has never happened before. Black Swan anyone?  We tend to not assign any risks to the unknown.
  • Deformation Professionnelle – The tendency to look at things according to the conventions of one’s own profession, forgetting the broader point of view. It’s important as a trader or investor to “think like a trader” but it’s equally important to be able to think of perceived problems and opportunities from multiple vantage points, eg. political, social (think BP oil disaster)
  • Not Invented Here – The tendency to ignore that a product of solution already exists, because its source is seen as “enemy” or “inferior”. Traders will ignore or refuse to use tactics that could improve their own strategy if they appear to be from a different school of thought.  For example, RTM faders and scalpers will refuse to use tools and tactics that they feel only applies to “Trend Traders”.
  • Outcome Bias – The tendency to judge a decision based on its eventual outcome instead of based on the quality of the decision at the time it was made.  When a trade works out for us we rarely look back and think that it may have been dumb luck.  We usually equate good outcome with a good decision, even though in the large sample the trade could have a negative expectancy.
  • Confirmation Bias – The tendency to search for or interpret information in a way that confirms one’s preconceptions. This is self explanatory.  This bias can result in you building a fortress of “evidence” around your other biases.
  • Money Illusion – The tendency of people to concentrate on the nominal (face-value) of money rather than its value in terms of purchasing power.  Look at this in another way: when you trade full-time it’s easy to lose sight of the true value of money or how hard it is to earn in a linear fashion.  I know that some days I just see digits.  We rarely stop to think about the work that it would take to replenish a trading account if it were to all disappear.  How many years working at a typical 50k per year (before tax) job would it take you to build back up your account to its present level?
  • Survivorship Bias – The tendency to concentrate on the people or things that “survived” some process and ignoring those that didn’t, or arguing that a strategy is effective given the winners, while ignoring the large amount of losers. This is a huge deal.  The only guys around in trading are the ones who haven’t blown out.  Is the strategy that great, or is it more likely that they haven’t hit their 10-standard-deviation event yet?  Or is the strategy mediocre and the surviving trader is exceptional at dealing with the 10-standard-deviation events?
  • Texas Sharpshooter Fallacy – The fallacy of selecting or adjusting a hypothesis after the data is collected, making it impossible to test the hypothesis fairly.  Refers to the concept of firing shots at a barn door, drawing a circle around the best group, and declaring that to be the target. I just like the fact that this is called the Texas Sharpshooters Fallacy.
  • Disregard of regression toward the mean – The tendency to expect extreme performance to continue. Have you ever had a great month and pushed your size the next month and had your worst month?  Yeah.
  • Disposition Effect – The tendency to sell assets that have increased in value but hold assets that have decreased in value. Not only do traders and investors hold onto losers for too long, but its a rare trader who can add to his or her winners.
  • Last Illusion – The belief that someone must know what is going on. Conspiracy theories seem to be common in trading circles.  The market appears to move intelligently in all time frames so there must be someone that has this whole racket locked up, right?  Surely there is manipulation but mostly people talk about Goldman Sachs buying every low and selling every high perfectly. It ain’t happening like that.

Source: Cognitive Biases – A Visual Study Guide.  Above definitions in italics are from that document.

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