Trading biases: The human flaws that cost investors money
Behavioral biases in investing affect even the most seasoned professionals — and are notoriously difficult to shake off
In a perfect world, the markets would be controlled by humans who rationally and objectively review the data in front of them before making decisions. Unfortunately, such a world is impossible to achieve, as trading biases are everywhere. Behavioral biases in investing affect even the most seasoned professionals — and are notoriously difficult to shake off. They waste time and cost traders money, but in the heat of the moment, traders are adamant they are taking the best course of action.
The best way to tackle investment biases is to be aware of them. By understanding our emotions, our personality traits and how we react to bad news, it’s possible to take a step back and examine whether we’re actually working in our best interest. Here, we’re going to look at some of the most common trading biases, how they affect behavior, and their potential consequences when left unchecked.
Biases in behavioral finance
There are dozens of ways that trading biases can present themselves.
This is where traders come to a conclusion based on the first piece of information they see, and subsequently struggle to adapt their thinking when new details emerge.
Let’s imagine Peter is analyzing the market at the start of a trading session. He sees the stock exchange take a sudden shunt into green territory — and as a result, the trader is convinced that a bullish trend is going to persevere for most of the day. Within hours, technical indicators begin to suggest that the opposite is true. Peter stubbornly rejects the latest information — and ends up missing opportunities because he was waiting for his shares to begin an upward trend that never came.
Although historical data has a place in trading strategies, and new information can throw traders off the scent of a real and established trend, one way to overcome this trading bias is to remain receptive to new information — striking a balance between the past and the present.
Many trading biases have something in common: they affect large numbers of people at once. This, in part, is because of how traders tend to jump on the same bandwagon. Perhaps they are drawn in to a company’s braggadocious claims, pay too much attention to the business pages in the newspapers, or become heavily invested in the buzz surrounding a burgeoning industry — blissfully ignoring extraordinary valuations, unsustainable levels of inflation and alarming levels of excess.
Herding means you have been seduced into following a trend despite your better instincts. Although it can be a lonely path to tread, relying on your own analysis is often the best course of action. Many people and businesses can be wrong at the same time — just look at what happened during the dot-com boom. The best approach to take if you want to avoid such investment biases is to take TV and newspaper coverage, social media posts and trends with a pinch of salt. By casting your net further and exploring opportunities that the mainstream aren’t covering, there’s an irresistible chance that you can become the person being followed. This also helps to prevent familiarity bias, where you only end up investing in what you know.
Good ol’ confirmation bias. It’s one of the classics when it comes to behavioral finance biases, and all too often, this human flaw can also extend into other parts of our lives. In short, this is where we favor information that validates what we think already, and ignore the facts that don’t conform with our world view. As we hear more things that we like, we end up becoming more confident and bolder with our assumptions, fully disregarding the mounting evidence that might prove us wrong. This is why channels such as Fox News are so popular — they filter out dissenting voices and focus on reinforcing what viewers already believe and feel. Alas, repeated studies have shown that Fox News viewers are less informed than those who watch any other media outlet in the US.
So… how does this work in terms of trading? Well, this involves clinging on to news headlines that justify a decision that perhaps, deep down, a trader knows is wrong. It involves completely ignoring technical indicators that would contradict their stance. This may result in them choosing unwise investments, or buying and selling stocks at inopportune times. By keeping an open mind and paying close attention to data and analysis that conflicts with your opinion, there is a better chance of you making a well-rounded decision.
Out of all the investment biases we have discussed so far, this is the one that has the potential to cost traders the most money. Disposition bias usually sees investors cash out quickly whenever they’ve made substantial gains, but hold on to positions after making a loss. Their determination to recover these losses and break even leaves them susceptible to losing even more money.
This is one of the most powerful examples where emotions take over, and the heart rules the head. Traders who are especially susceptible to disposition bias usually overcome this by having strict rules about how when they sell losing assets. By having consistent rules without any exceptions, passionate investors can inject discipline into their strategy.
Quick top tips for avoiding trading biases
- Don’t be overconfident. Always accept that you can be wrong, and be receptive to changing your mind when new information emerges.
- Accept mistakes. It’s never nice knowing that you’ve made a loss on a trade. That said, confronting your mistake immediately will prevent matters getting worse — allowing you to learn your lesson and move on.
- Be wary of trends. By the time you’re getting involved, it’s very possible that prices will be reaching their highest levels, meaning that you’ll have no choice but to watch your investment fall in value.
- Set clear boundaries. Take the time now to outline a clear strategy that you’ll follow come rain or shine — and make sure you don’t deviate from it.