Why traders need to understand cognitive bias
As a forex trader, you will be used to thinking on your feet, and making fast decisions. The forex markets are constantly active, and you need to keep on top on a lot of information to be a successful and profitable trader. The human mind is wonderfully complex and flexible, and many us thrive on this sort of challenge.
However, it’s important to be aware of the cognitive biases which may be subconsciously at work in your busy mind, and could be causing you to unintentionally sabotage your trading success. Even if you think yourself immune to biased thinking, it’s worth being aware of this recognised phenomenon in all financial trading markets.
Biases can be conscious, but they can also happen subconsciously, when the mind is working quickly and dealing with multiple information strands at once, such as when you are trading. This process is to some extent helpful and unavoidable, as otherwise the mind would become paralysed with cognitive overload.
We build up a series of mental shortcuts when we are learning to carry out new tasks, to save us the time and effort of thinking through every step of the way from scratch. However, some of these selective thought patterns can be detrimental to good forex trading, because we can make decisions without enough objective evidence.
Dozens of different types of cognitive biases have been identified by those who study trading psychology, but these are some of the main biases to be alert for in your trading behaviours.
Also known as the disposition effect, this is the number one enemy of forex traders. It’s a widely recognised behavioural bias throughout all types of financial trading, and it can undermine your success without you even realising what the problem is.
Disposition bias refers to the natural human tendency to sell winning assets to early, for fear of losing out, and to hold on to losing assets for too long, in the hope that the markets will soon take a turn for the better.
Research shows that the vast majority of forex traders are more likely to sell when they’ve gained money than when they’ve lost money. Over time, this can have a significant effect on your profit margins, and may lead you to becoming disheartened when you fail to understand why all your hard work and preparation isn’t paying off.
It’s not a straightforward problem to tackle, because this type of behaviour is often hardwired into the human psyche, and so it can be a subconscious process which is difficult to recognise. This is especially true when we are busy with the present moment, and under pressure to think fast and make quick decisions, as forex traders often are.
The human mind has a natural tendency to err on the side of caution. This has a sound evolutionary basis, because everyday decisions could literally mean life or death for our ancestors. Therefore, we have evolved to fear the pain of loss more acutely than we feel the elation and satisfaction of success.
In our everyday lives, we are also often conditioned to be loss-averse; for example, we are often drawn into shopping in the winter sales, even if end we up buying items we wouldn’t have done normally, are not exactly what we were aiming for, or didn’t really need. This can convince us that we are being economical, when in fact we are just spending more money.
The first step to overcoming your disposition bias is to acknowledge that we are all prone to it, no matter how confident you feel in your trading skills. It’s not a sign of a weak personality; it’s an innate human condition, so there is nothing wrong with admitting that you sometimes act on your instincts—it would be odd if you didn’t do this, in fact.
The best way to tackle the issue is to make a clear a trading plan and stick to it as closely as possible, and keep a detailed journal of your trading progress. Review your records regularly, and be vigilant for any situations where you may have locked in a profit at too early a stage in a trade, when a bigger profit could have been taken if you’d waited.
Also note any situations where you have hung on to a losing trade, for fear of turning a hypothetical loss into a real financial loss. Unless you have well-researched and objective evidence which leads you to believe that the market conditions will change in your favour, it is always best practice to avoid hanging on with blind faith for a market swing.
This refers to giving too much weight to one piece of information over another, usually in the form of the earliest information we have found to base a decision on. The temptation is then to plough ahead with a course of action, at the expense of any new information which may come to light.
Although we may think we have taken into account the new information, we may do so in a way which means we subconsciously use the first piece of information as a reference point, instead of making an objective unbiased assessment. This may be to save us from the mental labour of revising or reforming our original plans.
The problem with anchor bias is that it can make us blind to the flaws in our original plans, and cling to a strategy for which there is no longer any logical evidence that it is sound.
For example, you know that the market rate for fixing a fault with your boiler is £70, and you ring a plumber who say they charge £100. You then ring another plumber who charges £80, and you decide to accept the quote because it is less than £100, even though you know the going rate is £70. This is an example of anchor bias.
Avoiding anchor bias is a difficult thing to do, because it’s one of the most powerful subconscious forces that drives our behaviour. However, by developing the mental discipline to stick to your trading plan, and make thorough and logical assessments of all the information you receive, you will put yourself in a stronger position.
The bandwagon bias
Sometimes also called the drag effect or the herding effect, this is a well-known cognitive bias which describes the human instinct to follow the crowd, rather than continue with a pattern of thought or behaviour which is in the minority. Conforming to whatever is the current ‘norm’ can be way of attempting to keep safe and avoid risk.
This can either a subconscious process, or a deliberate decision by people who fear becoming isolated from mainstream opinion, and prefer to be on the winning or most popular side. It may also be the result of a person assuming that because lots of people are doing something, it must mean it is the right thing for them to do as well.
The problem with the herding instinct is that it can mean we avoid thinking critically about new information, with an independent and objective point of view. In terms of trading, this could mean paying too much attention to media headlines about the financial markets, or anecdotal stories about the behaviour of other forex traders.
Following the herd in a market pile-on can lead to painful losses if the markets don’t move in the predicted way, or if you get caught by a sudden sharp rebound. It is always best to stick to your trading plan, and learn how to make an independent assessment of all the information that is available to you.
This is when we subconsciously give more weight to information which confirms our preconceived ideas and opinions. This can lead traders to seek out justifications for their intended cause of action, rather than to make objective assessments of the available information.
This is something which new forex traders may be particularly prone to. It’s when you pay too much attention to the end result of a process, rather than the steps you took which led you there.
For example, you might have made a profitable trade through sheer good luck, rather than because you based your actions on market knowledge and technical analysis. Other times, you may have been tempted to ignore your risk management plan, and dropped lucky.
Results like these can lead us to repeat the same actions in the hope of achieving the same outcome, no matter how unsound the process was. They can also lead to us becoming overconfident, and conclude that that our previous attitude to risk was too cautious.
These are very dangerous patterns of behaviour to fall into in forex trading. The only path to steady profits is by sticking to a risk management plan and careful research—any other approach is no better than gambling.
The takeaway for traders who are keen to avoid cognitive biases is to learn how to think critically and independently at every step in the journey. This means leaving your emotions aside, and avoiding giving too much weight to any one particular piece of information or line of thought.
Mastering this frame of mind will help you become a more consistent and profitable trader within a much shorter time frame. For more information on how to use an instant prop funding firm, visit our website today.