Disclaimer: The content of this article is sponsored.
Main takeaways:
Emotions are embedded in all human endeavours and cannot be put to one side when trading. Learning to control how emotion affects your thinking will help with a successful trading strategy.
Cognitive biases can directly impact sound investment decisions.
A well-developed trading plan supports the elimination of cognitive biases and emotional decisions.
Buying and selling securities, such as currencies or commodities, seems like a straightforward principle based on tangible indicators, but trading does not come naturally to the human brain. Many factors, such as beliefs and backgrounds, influence the ebb and flow of cognition. That means emotions and other non-factual drivers – aka cognitive bias – can affect a trader’s day-to-day choices.
Cognitive bias often hobbles successful trading. Controlling this phenomenon starts with awareness.
Emotional decisions
Emotional decisions can lead to dire consequences, especially when trading. Impulsive buys and sells rarely stem from organised thought processes, and thus they can be compared to the haphazard spin of a slots reel.
Trading psychology suggests people have three core responses when faced with challenges: flee, fight, or freeze. These knee-jerk reactions can prevent an individual from sticking to their trading plans. Before addressing cognitive biases, individuals must rein in emotional trading by:
Identifying strengths and weaknesses
Devising and implementing a trading plan
Being patient
Taking a breather after a negative spell
Accepting positive gains
Keeping a log to pinpoint trends
Many trading brokers will offer support. For example, IG offers structured support through a team of trading experts. The IG Academy and IG Community provide valuable guidance for new and experienced traders. You can also learn more about trading psychology at IG’s new Master Your Trading Mind hub.
Five pillars drive this mastery and show you how to recognise a cognitive trading bias and manage and eliminate it. Dive in and discover how to:
Manage your emotions to ensure subjective biases don’t cloud your decisions. Stepping back and applying emotional maturity to make objective choices helps with successful trading.
Develop sound trading habits from the start to avoid cultivating bad habits that stick. The latter is difficult to overcome once they take root. IG teaches you the basics for good trading habit foundations.
Tap into your trading DNA and capitalise on your strengths by getting to know your instinctive trading behaviour. Self-awareness makes it easy to identify the good and the bad, and when honing the good, you can strengthen your trading plans and actions.
Recover after the highs and lows of trading to keep your mind and body healthy. Trading is a risk-based enterprise, and one needs tools to handle impacts on one’s person.
Find and nurture trading inspiration to keep your motivation on solid ground. Trading won’t work if you do it when you feel like it. Learn how to inspire yourself and develop a holistic, inspired approach for your trading journey.
Confirmation bias: Seeing what one wants to see
Humans naturally tend to source and follow the information confirming their views rather than objectively weighing all angles. They do this to verify their predetermined thoughts or feelings regarding a matter.
In trading, someone bullish about a specific stock will hunt for content that supports the bias. They will consciously or subconsciously steer away from opposing information or opinions. Consequently, the individual believes they have done the due diligence to support an investment decision.
This partiality clouds not only judgement but also objective investment decisions. Looking at all sides of any investment before putting money down is essential.
Retrospection bias: Thinking one has a handle on market prediction
Retrospection bias occurs when a person looks at past trading successes and thinks that it means they understand and can predict markets. Linked to this is the notion that any trading failures are due to unpredictable market factors.
It is important to realise that markets can change in the blink of an eye. Over-confidence, which over-simplifies trading, interferes with effective decision-making.
Recency bias: Thinking new news is better than old news
Often, traders attach more value to the latest or recent indicators. Therefore, they will discard more historical information, such as on a stock or commodity. This subconscious thought process creates a kind of tunnel vision where traders only regard the here-and-now performance of financial instruments.
For instance, when investing in stock, a trader will only look at the positives of organisational changes and will not include the negative financial performances for the past three quarters.
Availability heuristic bias: Shortcuts to ease decision-making
In most situations, heuristics – quick mental processes for problem-solving and decisions – are a beneficial tool in one’s arsenal. In trading, it can be counter-productive.
Availability heuristic bias is when traders base their investment choices on information they can easily remember. For instance, if traders are looking through their platform and come across a company that has been recently featured on the news, they are more likely to buy its shares.
Whether the inputs came from the news or the latest trading fads, they remain snippets of the whole picture. The complete picture can only be gained through careful research, a bias that blurs the lines between market and personal trends.
Herd mindset bias: Playing ‘Simon Says’ with investments
The fear of missing out (FOMO) can have detrimental consequences in trading. Many traders go with the flow of the crowd and thus against their research findings. One such example is the Dogecoin buzz in 2021, which turned out to be more hot air than any long-term substance.
Anchoring bias: Building a puzzle with just one piece
When using single or limited pieces of information to guide investment decisions, a trader adds weighty value to that specific detail. For instance, someone buys up ‘cheap’ stock because the same asset was previously traded at a higher price. Previous asset prices do not and cannot inform successful trading.
Loss aversion bias: Fear of taking the plunge
Traders sometimes end up in a rut because they fear losses. Trading includes risks, gains, and losses.
Avoiding an opportunity or sticking to a losing deal, despite the plausible benefits of another investment, causes stagnation. Losing is, at times, a given in the trading game.
Narrative pitfalls: Looking for happy ever-afters
A good story will always grab the attention of those in trading. It can be anything, from buffeting risks to a start-up making a bang on the markets.
The tendency to invest in a ‘good narrative’ rather than an established and ‘boring’ narrative can be costly. An example of this bias is investing in a fluctuating cryptocurrency, or cannabis, instead of stock in a 100-year-old retailer.
Correlation bias: All for one and one for all
Correlation bias, or representativeness heuristic, is the belief that the same types of assets are somehow related and can therefore share the same ups and downs on the markets. The notion is risky and can lead to significant losses.
The good performance of one stock does not necessarily influence the stock value of another. The same goes for specific assets, such as precious metals.
Status quo bias: Kicking against change
The markets are in constant flux, and traders should act similarly. It is not good to stick with one asset type or a particular investment strategy just because one wants things to stay the same.
This bias affects sound investment decisions, as traders stick to their guns even when faced with opposing information. For instance, price drops in stock may be seen as a phase and not a trend, causing traders to continue losing money as they believe it is just a temporary setback.
Oversight bias: Overlooking one’s shortcomings
Trading hypocrisy is a pitfall that can lead to losses. It is easy to see the biases of others and far more tricky to identify them in one’s own tactics. This inclination can close a trader’s ears and eyes to objective advice and information.
Addressing cognitive biases in trading
First and foremost, traders must pinpoint and acknowledge their cognitive biases. Often these are subconscious responses that need introspection and honesty. Once traders know of a bias, they can begin handling the issue.
These cognitive biases are not fixable and are not something that goes away quickly, but they are part of the human makeup. One can only manage them through a well-developed trading plan that factors in everything from impartial research and risk management to flexibility and trading psychology.
Having gained a degree in economics, Alan entered the world of financial services starting his career in London and then moving to New York for a number of years. His first post at a City bank saw him establish a reputation as an forex trader. Having recently returned from New York after eight successful years, Alan is now a prosperous trader in his own right concentrating on commodities and forex.
