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Are you a trader and want to improve your trading skills and increase your profits? Did you know that cognitive biases can significantly influence your trading decisions? Cognitive biases are inherent errors of thinking that occur when people process information, and they prevent us from accurately understanding reality, even if we are given the necessary data and evidence to form a more accurate picture.
Let’s take a look at some of the cognitive biases that traders and investors are prone to, and then I’ll tell you what you need to do to mitigate them.
Negativity bias: This bias refers to the tendency to give more weight to negative information than to positive information.
Loss aversion bias: This refers to traders’ tendency to avoid losses over acquiring equivalent profits. In other words, the pain of losing is psychologically about twice as powerful as the pleasure you get from winning. And this bias can lead traders to behave irrationally.
Gamblers Misconception: This bias refers to the belief that future events are influenced by past events, when in fact they are independent.
Confirmation preference: This bias refers to the tendency to seek information that confirms pre-existing beliefs and ignore information that contradicts them.
Hindsight bias: This bias refers to the tendency to believe that past events were more predictable than they actually were.
Anchoring bias: This bias refers to the tendency to rely too heavily on the first piece of information encountered when making decisions.
Bandwagon Effect: This bias refers to the tendency to do or believe things because many other people do or believe the same thing.
Overconfidence Bias: This bias refers to the tendency to overestimate one’s abilities or the correctness of one’s beliefs and judgments.
Recency bias: This bias refers to the tendency to weight recent events more heavily than past events.
Own sake: This bias refers to the tendency to attribute positive events to one’s own character or actions and negative events to external factors.
There are many more cognitive biases, but these are just a few that are relevant in a field like trading. They enter the picture and structure the way we perceive market information, very often in ways that are not helpful to our bottom line.
Related: How To Take Cognitive Bias Into Account As An businessupdates.org
Table of Contents
Why You Can’t Eliminate Prejudice Completely
Cognitive biases are intrinsic to human thinking and perception, and it’s important to remember that just knowing these biases doesn’t necessarily free you from them. As a trader, your trading approach must include mechanisms to limit such biases, or you will be shooting yourself in the foot repeatedly – and getting nowhere in terms of consistency.
Again, you can’t just rid yourself of prejudice. Some people seem to think you can, but to that I’ll say this: not seeing your biases is a bias in itself (blind spot bias – the tendency to recognize biases in others when we fail to see biases in ourselves)
Prejudice obscures the complexities of the world for us – they are simply how we see and think about the world. They are unavoidable. That said, they can be mitigated. For example, it’s helpful to remember that our brains have evolved these biases to deal with information overload.
The world is a complex place and we are constantly bombarded with all kinds of information reaching our five senses. The best estimate I’ve read about this is that there are about 11 million bits per second of information available to our senses from moment to moment. The research also tells us that our brain has a limited amount of information it can perceive on a conscious level, and that number is about 50 bits per second. That’s a big difference, isn’t it? There are 11 million available, and only 50 coming in…
So it’s not surprising that this means there’s a tremendous amount of filtering going on in our brains, and that takes the form of habits in the way we perceive and think about things. We constantly filter information and select those that already fit our worldview.
And that’s not all. Within that mess of information available to our senses, there is uncertainty. What do I mean by this? Well, there are many deep and important questions about reality that we don’t know the answers to, and that lack of “knowing” and lack of certainty is confusing; it worries us, so we fill the gaps with our own stories and map everything with our existing mental models.
But some of the information we filter out is actually useful and important, so what does the mind do? Well, it fills the gap with information it already knows, and sometimes this is good enough, but often it isn’t.
To act quickly in a world full of dangers, our brains must make split-second decisions that could affect our chances of survival. But quick decisions and reactions are often counterproductive because they are usually rooted in short-term emotional gratification. And short-term emotional gratification often goes against our long-term goals — which we rationally know is better for us.
Related: 13 Cognitive Bias That Are Really Ruining Things For You
How to limit the effects of cognitive biases
Now there are ways to mitigate the effects of cognitive biases and improve your trading performance. The key word here is ‘limit’. Again, biases are an inevitable part of human thinking and perception, and we can only mitigate the extent to which they affect our results as traders.
You can use tools like meditation to become more aware of your inherent biases, thoughts, and emotions. I’m very big on meditation, given my background as a meditation teacher, and I’ve found it has a great impact in helping us develop self-awareness and emotional maturity. Living such an examined life also helps us accept that we are permanently biased beings and that there is nevertheless room for improvement. We can get better… not be perfect, but better.
So meditation is a way to limit the role of biases in your trading process. Another way is to adopt a rules-based trading approach. “If X happens, I’ll do Y;” “if Y happens, I’ll do Z.” You don’t need to have hard rules for everything — just for the tough decisions where there’s a lot of uncertainty and potential risk. Examples of tough decisions include the size of your position, stop-loss placement, and what to do in the event of a gap below your stop-loss.
Soft rules are generally sufficient for all other lighter decisions, such as your profit target or when to trade.
In conclusion, by understanding the ways in which cognitive biases can influence your trading decisions, you can develop effective strategies to mitigate their effects and improve your profits. Keep in mind that our brains have developed these biases to deal with information overload and the complexity of the world. But by pairing self-awareness with a rules-based trading approach, you can make more informed decisions based on objective criteria and increase your chances of trading success.
Related: Trading Psychology 101 – How Traders Can Control Their Emotions And Achieve Success