October 31st 2007
5 Cognitive Biases that Ruined My Trading
I’m almost finished with Way of the Turtle by Curtis M. Faith. In the book, there’s a section on some of the cognitive biases that traders and investors experience. A cognitive bias, according to the book, is a “distortion in the way people perceive reality”. I thought it would be interesting to list my Top 5 and how I’m dealing with them.
1. Loss Aversion:
Simply stated, it is the preference for avoiding losses instead of acquiring gains. When I follow the rules of my system and lose $100, I feel the pain is more intense then if I had missed a trade that would have made me $100.
Where I have seen improvement is I would rather take a trade because I am following my rules and lose $100 then not take the trade because I ignored my rules and avoid losing the $100. Traders who are prone to loss aversion would rather ignore their rules and not lose $100 than follow their rules and lose $100.
The reason loss aversion is “bad” is that it causes the trader to violate their trading rules. Your trading rules are what give you the confidence that you will win over the long term. Trading rules are what give you an edge. When you ignore them, you’ve just thrown a huge monkey wrench into your viability. Ignoring your trading rules would indicate that you really don’t have confidence in what you are doing. Without a clear, unemotional decision making process for your trading activity(trading rules), you are gambling.9
2. Outcome bias
When I judge a trade based on how well the trade performed rather than how well I adhered to my system, that’s outcome bias. I struggled with this cognitive bias early on. When I had a string of losers I would begin to question the trading method I was using. It would cause me to flip flop methodologies which ultimately led to my 2nd demise. First it was CANSLIM style investing, then I hit a couple of losers and I was scalping futures, then trading gaps intraday. I ended up losing my second trading stake pretty quickly.
3. Recency bias
Recency bias is placing greater weight on current trading performance relative to previous trading performance. It goes hand in had with my outcome bias. When I was flip flopping methods, my current performance had far more weight in my decision making process than any success I had previously with other methods. I had made up my mind that if it wasn’t working now, it wasn’t any good. It was such a train wreck. I don’t think I write well enough to do it justice 
4. Bandwagon effect
The Bandwagon effect, as Mr. Faith states in his book, is the tendency to believe things because many other people believe them. I would like to think I am a little more independent than this bias sounds. However, it’s important to be true to yourself. I know in the past, I have tried trading methods and taken stock picks because I’ve heard it mentioned by several sources. What really sucks is that these weren’t even trusted sources. I believed it because I heard it enough.
5. The Law of Small Numbers
Borrowing again from Way of the Turtle: This is “the tendency to draw unjustified conclusions from too little information”. How could I have switched trading methodologies so quickly when things weren’t working. I mean, I was switching the way I traded when the system didn’t work after a few days. What kind of indicator of performance is that? At most you would think I would have stayed with CANSLIM investing from the beginning. There’s decades of examples that imply this system is profitable. Not that I am advocating trading on the implications of a system’s past performance, but I had no experience in back testing at the time. Ultimately, the belief in the law of small numbers was just another nail in the coffin.
As I write this post, I get a pit in my stomach. If I had known about how important psychology is to trading successfully, I would be farther ahead, and would not have blown out twice.
However, experience is the best teacher. Without making all those mistakes, I never would have become the student of the market and of trading that I feel I have become.
How did I recover? I got a mentor, learned a system, and focused on trading that system as best as I could. I still grapple with these cognitive biases. I’m not a machine and being a discretionary trader doesn’t help.
I’ve learned to deal with my cognitive biases in three ways:
1. Focusing on being the best trader of my system that I can be.
2. I also my risk and reward in terms of R multiples. The helps because I no longer think of risk and reward in terms of dollars.
3. Trade longer time frames. The less I am in the market, the less these biases can impact me. I still day trade occasionally, but trading with a slightly longer time frame really helps.
Hopes this helps. If you haven’t read Way of the Turtle
