Most traders and investors tend to think they are right most of the time, even when they are wrong (Psychological Trading Mistakes). This is caused by what is known in psychology as “cognitive bias”, which often leads to bad trading decisions and bad trading decisions will lead to losing money, over and over again. – Reza Abbaszadeh
The bad news is that you will never entirely overcome your cognitive biases (Psychological Trading Mistakes). because it’s in our nature as humans. The good news is that once you are aware of your cognitive biases (Psychological Trading Mistakes), you can stand a better chance of becoming a successful trader.
Today we’ll work on our trading mindset and you’ll discover the most dangerous mistakes you make in your decision-making process and you’ll learn how to correct them. Before we continue, if you are new here, make sure you subscribe and click the bell icon to enable notifications and leave a like to show your support.
What is a “cognitive bias”?
I will try to keep it very simple and not overcomplicate the concept: A cognitive bias is simply a tendency that leads our thinking away from a correct judgment and it will result in Psychological Trading Mistakes.
The most important Psychological Trading Mistakes that every trader or investor can relate to:
The first one, the confirmation bias.
So, let me take you as an example. You see a stock trending on social media. The stock has already gone up 300% in just a couple of weeks, as the company announced a new product they are currently testing, that is showing great promise. You recall this company being mentioned on CNBC or Bloomberg a couple of days ago. You go and “google” the company and looks for articles that would suggest the stock might keep on increasing in price. You find some articles confirming that the company’s new product will be a hit worth billions of dollars.
You read all the positive comments about that company on different social media platforms. You then look at the chart and although the
stock doesn’t fit your technical criteria and it may be overextended or overbought, you recall that some TV analyst predicted a price of is $30 per share and the stock is now trading at 10$ per share, so likely to at least triple from there.
You decide that all stars are aligned and this is the perfect chance. You put all your savings in the stock and start thinking about the things you will buy with the profit.
This is the confirmation bias: a tendency to actively seeking only information that confirms your beliefs, and you reject or disregard information that disconfirms your beliefs. We all experience confirmation bias. You have to avoid Psychological Trading Mistakes.
How to overcome confirmation bias?
It’s hard and it’s up to you to recognize it and be aware that it affects your decision-making process. The first thing I do every time I enter a trade is to make a list of the pros and cons and reassess it with an open mind. Always consider the other side of the trade you take. You have to avoid Psychological Trading Mistakes.
The second cognitive bias is the self-serving bias
Let’s continue with your story. In the next few days, the stocks decrease in value and go against your position. Not only you have a losing position, but the stock keeps going even more against you. However, you still believe that your reasoning is still correct. After all, you did some research, and TV analysts and social media confirmed your view. You are absolutely convinced that you are not wrong.
The ones that sold the stock are just amateurs and are selling the opportunity of a lifetime. You think to yourself that the stock is probably being manipulated by investors wanting to buy some more shares at a lower price. You know that the stock will recover as soon as the market finally understands how the company will be worth billions soon. You see the problem here? You can only see information that fits your puzzle, regardless of whether the puzzle is correct or not.
This is the self-serving bias: a tendency to focus your attention on the information that enhances your self-esteem and protects you from any negative feedback.
Self-serving bias is also known as the attribution bias in some books. Basically, when things go well, it is because of you. When things go south, it is definitely not your fault. Come on, admit it: after a fantastic trade with a nice profit, you start to feel like a genius, thinking that your trading skills made it possible. After a losing trade, you blame your broker, your computer, your chair, your zodiac sign. That’s the self-serving bias. The lesson here is to assume responsibility for everything, including your losses.
As a trader or investor, try not to shift blame because it does not help you progress. What does help? Taking responsibility to find out what went wrong and doing what is needed to improve. You have to avoid Psychological Trading Mistakes.
How to overcome self-serving bias?
Consider keeping an investment or trading journal. Reviewing a trading journal can help you easily identify strengths and weaknesses in your trading. It can also help you identify mistakes that you continually make. Also, it can help you to identify when and why your analysis was correct. You have to avoid Psychological Trading Mistakes.
The third cognitive bias is the hindsight bias
The stock fell from 10$ to $3 and your trading account gets a margin call. Unable to cope with the pain of that loss anymore, you finally realize your mistake. You start to recall all the red flags you noticed before buying the stock. You remember that you saw many articles saying the company’s product was not ready yet and the chances of releasing it were slim and on top of that, the stock was clearly extended when you entered the trade. You have to avoid Psychological Trading Mistakes.
How to overcome hindsight bias?
After reflecting on it, it was clear in your mind that you knew this trade was going to be a loser right from the start. This is the hindsight bias: a tendency to represent the past not according to what you experienced, but according to what happened later. So basically hindsight bias can lead you to believe that an event was more predictable than it actually was. You have to avoid Psychological Trading Mistakes.
Another cognitive bias is the recency bias.
After a week, you see another opportunity. Another company, from the same sector. There’s a lot of hype on social media about this stock. It even fits your technical criteria, a no-brainer buy. But you lost money on the previous trade. Due to your recent experience, you decide to skip that opportunity, you’re afraid.
That’s the recency bias, our brains naturally put more weight on recent experience and we avoid trades that remind us of our recent losses. You have to avoid Psychological Trading Mistakes.
How to overcome recency bias?
Write out a trading checklist with your criteria from your trading plan. This way, you are more likely not to enter every trade unless it fulfils all of the criteria. You will enter a trade only if it matches your trading plan criteria, no matter if you had a losing or a winning trade before. You have to avoid Psychological Trading Mistakes.
Another dangerous bias is the illusion of control.
You think that you can control if you’re next trade is profitable and everything is under control. You are convinced that you have control and that’s why you increase your lot size. Nothing can go wrong. Thinking that you can control the outcome of your next trade, is the same as believing that you control the market. You clearly don’t.
The illusion of control comes after a winning streak and is extremely dangerous. You increase your lot size and when the trade goes against you increase your stop-loss, because you absolutely know that you’re right and you guessed it; you get a margin call after a winning streak. One bad trade can wipe out your entire account. The market doesn’t care you won 10 trades in a row. We work in uncertain conditions. You have to avoid Psychological Trading Mistakes.
How to overcome control illusion bias?
Recognizing that we have no control over the market is the first step towards managing our risk. The lesson here is to avoid seeking certainty and control. That’s why it’s better to focus on controlling what we can control. Our actions and emotions. You have to avoid Psychological Trading Mistakes.
The last bias is the bandwagon effect.
You buy a stock because everyone else seems to be doing it, even when there are no good reasons for doing so. Another example is when you hear everyone saying that the bull market will stop soon. You hear words like recession and bear market. The news, gurus, and forums are all bursting with negativity. You look at your charts with your technical analysis tools and you don’t find anything bearish.
Then you look at several stocks and find some bullish setups. But because everyone was saying that the bull market would come to an end, you sell all your long positions and skip new long trades. The outcome of the market does not matter, whether it continued to rise or fall. You have already joined the bandwagon bias because you follow the herd instead of your analysis. You have to avoid Psychological Trading Mistakes.
How to overcome bandwagon bias?
The lesson here is to listen to your own analysis and ignore the voices of the masses. I’m not saying you should adopt a contrarian mindset and always go against the herd. That is not the case. Just trust your own analysis. You have to avoid Psychological Trading Mistakes.
If you learned something new, consider subscribing to our channel, click the notifications icon and don’t forget to leave us a Like. Until next time. – Reza Abbaszadeh