Trading biases to avoid as a novice trader
One of the toughest things in trading is making instant decisions, which is when our biases kick in. You can't avoid them, but you can take steps to minimise their impact
There is no shame in being a rookie trader. Even Nick Leeson, the 1990s rogue trader, had to start somewhere. There is also no shame in making mistakes, just as long as you learn from them and move on. And try to avoid bringing down a major bank.
One of the toughest things in trading is that you have to make decisions quickly, while taking in vast amounts of information. Sometimes, it is too much for the brain to process, so rather than making a decision based on facts and figures, we rely on predetermined beliefs and prejudices – also known as biases. And in trading that can be a dangerous thing.
The bad news is you can never fully escape your biases. They are part of who you are. The good news is that once you are aware of your biases, you can minimise their influence when making decisions.
The study of trading bias is called behavioural finance, which looks at how the psychology of trading affects markets.
There is a huge number of behavioural biases in investing for you to get your head around, which can be categorised as emotional bias and cognitive bias trading.
However, there are three key types of bias in trading, which commonly affect novice traders.
Loss aversion bias
No one wants to be a loser, right? But in trading, losing is par for the course. A good trader needs volatility and risk, without it, trading simply wouldn’t exist. But this also means all traders suffer losses.
It’s how you handle loss that matters – and some handle it better than others. If you are more focused on protecting your losses than increasing your gains, chances are you’re being influenced by loss aversion bias – also known as ‘‘refund-itis’.
Examples of loss aversion bias
- Selling a stock that has gone up slightly in price, in order to realise a gain, even though your analysis tells you the stock should be held longer for a far larger profit;
- Favouring low-return, guaranteed stocks over more promising investments that carry higher risk;
- Not selling a stock, despite analysis screaming at you to SELL SELL SELL;
- You convince yourself an investment is not a loss until it’s realised (ie, it’s been sold).
How to avoid it
The trick to accepting your losses is to create a trading plan and stick to it. Stop losses are your friend, but only when used wisely.
The point of a stop loss order is to help you worry less about volatility, as decisions are made for you. If the price of a stock dips below a certain price, an order to sell is automatically made. So they take the emotion out of trading in the heat of the moment.
Don’t set stop losses that are too wide or too narrow – and hold your nerve! Don’t be tempted to move your stop loss, or cancel it.
Also, it’s worth bearing in mind that a stop order isn’t guaranteed. Markets move fast, and a stop order may not be able to be implemented if your order is piled behind a load of other stop orders, or an order is too big and needs to be done manually.
This is similar to loss aversion, in that investors hang on to unsuccessful assets for too long; however they also exit successful positions too early in order to secure a profit.
Why? They believe a good run can’t last for ever, so it’s better to quit while you’re ahead; or a poor run has to end soon, so it’s best to hang on. And on. And on.
This runs contrary to trading trends, which often show that investments performing well often continue to perform well, so should be held, while investments performing badly will continue to perform badly, so should be sold.
Examples of disposition bias
- Remaining idle during losses and hoping for a price swing in the right direction;
- Quickly closing profitable positions – and missing out on more profit;
- Spending too much time in losing trades, rather than taking your losses;
- Not giving profitable trades more time to work in your favour.
How to avoid it
Avoiding disposition bias is all about looking at the relationship between the potential loss and potential profit. Ideally, your potential profit should be at least two to three times the size of your potential loss.
Having a plan in place is imperative. Set a profit target when you open a trade, and don’t to be tempted to exit too early.
As with loss aversion, stop losses are an effective tool for inoculating against the disposition effect, which has been proven by a study from The Open University Business School in Milton Keynes. Again, stick to the plan.
Another solution worth a try is ‘hedonic framing’, which can make gains feel stronger and losses less painful. The idea is that investors trick their biases by making themselves think of a single, large gain as parcels of small gains, and to think of small losses as a single, large loss.
Wanting to be part of a social group is part of what makes us human. Whether it’s eating the latest superfood, or binge watching a Netflix series, we want to fit in and we don’t want to miss out. Plus, going against the crowd typically triggers fear. What if we make the wrong decision?
In trading, herd bias means you make the same investment decision as other traders, simply because it’s the majority choice.
While traders know they should stand back and analyse the situation, they can’t help but get caught up in the trade, the atmosphere, the news – all of which makes thinking logically difficult.
According to a survey by the CFA Institute, herding is the topmost bias affecting investment decision making.
Herd bias is particularly common among novice traders, who often follow trends because they don’t have the confidence or experience to make their own decisions.
Examples of herd bias: how to avoid it
The key thing to avoiding herd bias is to do your research, think for yourself and make trading decisions based on the information available, not on mob mentality.
By analysing the charts and watching trends, you’ll be able to see the real patterns and market movements behind the trends, rather than blindly following the crowd. As your mum probably said to you: “If they told you to jump of a cliff, would you?”
Don’t be a sheep. Be an individual, informed, and insightful trader. Although it is worth bearing in mind the herd can sometimes be right, so don’t automatically disregard the consensus.
- Making decisions based solely on the actions of other traders, foregoing your own private information;
- Reacting to commonly known public information and making similar investment decisions;
- Jumping ship to negative news coverage, or a sell-off, without studying the market;
- Exuberant trading causing an investment bubble, because of fear of being left behind, while ignoring the fundamentals of investing. This is what happened in the late 1990s/early 2000s with dotcom stock, which was driven by over-confidence and over-speculation.
FURTHER READING: Trading psychology: getting in the mindset of a successful trader
FURTHER READING: Trading biases: The human flaws that cost investors money