By Taro Hideyoshi – Over time, experts have identified the most common biases that usually affect behavior of traders. Curtis M. Faith, who had been the most successful of Turtles, also mentioned about this in his book “Way of the Turtle“.
According to the book, people always distort perception of reality when it comes to trading. Scientists call these distortions as cognitive biases. Curtis listed some of cognitive biases that affect trading. I think it is interesting to discuss some of them that have occurred mostly among traders.
Getting know your biases is the first step to avoid them. Here are some of cognitive biases that I think many traders has experienced.
1. Loss aversion
This bias is to have a strong preference for avoiding losses over acquiring gains.
For example, traders usually feel the pain for losing of $100 more intense than they missed a trade that would have made them $100.
2. Disposition effect
It is the tendency for traders to lock in gains and ride losses.
Instead of letting profits run, many traders decide to take out their small amounts of profits. It is because of their fear to give back the profits, but when it comes to losing trades they always keep the positions until they lose large amounts of their capitals.
Traders who exhibit this tendency will face large losses and become very difficult to make up from winning trade.
3. Outcome Bias
This is the tendency to judge a decision by its outcome rather than by the quality of the decision at the time it was made. This bias causes traders to put too much emphasis on what occurred rather than on the quality of the decision.
In trading, even a correct approach can result in losses, and then they may evaluate the approach negatively because of the negative outcome.
4. Recency bias
The recency bias is placing greater weight on recent performance relative to previous performance. A trade that was made yesterday weights more than trades from last weeks.
This bias affects the trading if the outcome series of recent trades were lost, it will cause most traders to doubt their method and decision-making process.
5. Bandwagon effect
This effect is the tendency to believe things because many others believe them.
The example for this effect is the bull market. When market is going up for sometimes, it pursues many traders to believe that market and buy more. Hence the market will go further up, seemingly, unstoppable.
About the Author
Taro is an experience trader who trades in stocks, futures, forex. He strongly focuses on technical analysis, trading systems and money management.
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