• Jan

The Four Horsemen of the Apocalypse (trading psychology)




The purpose of this article is to lay out some of the most common cognitive biases when it comes to trading, some of which might be very familiar and some slightly more deceptive or shadowed. This post might not provide much of practical value since one truly understands biases only after the fact of many mistakes being made, where if one was trying to learn them before that it would be very hard to do so, as being objective to thyself without the experience of mistakes is more or less a non existent thing. However there might be some useful conclusions being made that tie up the key aspects which trader should be always aware of, even after many years of trading experience.


The dictionary outlines bias as:


-cause to feel or show inclination or prejudice for or against someone or something.

Example: "readers said the paper was biased towards the Conservatives"


It is no surprise that individuals tend to prefer to operate with biases frequently since one of the things that individuals strive for is consistency, not just consistency in terms of how they view the world but how the world sees them back. This makes holding to particular bias more consistent as opposed to the approach where the individual has full adaptivity and no pre-set stance for or against anything.

Being too flexible and adaptive is somewhat chaotic as it does not allow to put the individual on firm ground, whether it's physically or mentally which makes biases somewhat help with the issue of creating more stability even if that is for un-optimal reasons and the subject faces more negative consequences than benefits for doing so.

It is even hard to test for yourself whether your constant tilt towards biases is causing you harm or giving you a positive advantage since to test that one has to step outside of him-her-self and go back to the method described above-to be fully flexible and objective to thyself.

All this makes often individuals who are exposed to biases frequently less prone to question themselves or their perceptions, because there is no easy solution of doing so, before gathering all sorts of the mistakes under the belt.


Think of thought processes behind the trading idea in this way, in terms of flexibility, conviction, objectivity, and the duration:

-No opinion (idle, self-exclusion)

-Short term view (short term duration, flexible, changeable)

-Bias (medium duration, still adaptable, objectively or non objectively backed)

-Strong bias (long duration, strong conviction, either very right or very wrong)



If a trader wants to develop certain convictions behind trade idea there has to be certain thought placed into it as well as some sort of bias. Without no bias at all one is declaring full neutrality, which one cannot be if one is to place a long or short bet on the trading asset.

But there is a delicate balance between having too much conviction on an asset where the trader has such a strong bias that it is unable to change it no matter what price does, or the opposite of this having such a weak bias or opinion on an asset that trader keeps flip-flopping the direction of the trade from long to short every 5 minutes. Neither of those two is the ideal approach, and if the trader finds him/herself operating with such a thought process it is very important to stop trading and going back to "drawing board".


So ideally the trader is aware of all the work, research that went into a certain thesis, but at the same time is fully aware of all potential biases that are being present on this particular thesis to not fell victim to them.

Ideally, very strong discipline on cutting the losses well will help a ton with fighting or preventing all sorts of biases to cause damage to trading equity, however, it will not solve all issues. Even a trader with the great discipline of cutting losses can still be subject to too strong conviction/bias on the asset, and giving a 100 of entry attempts even though if losses cut quickly will still contribute to large negative P/L.



I find a great exercise to know what kind of game you are playing on every trading day. Put yourself realistically in the shoes of what your contribution to liquidity is so that you can gauge what everyone else means to you (short-selling liquidity and buying liquidity).

So rather to being stuck in your head and thinking just because you cracked a perfect thesis on the certain instrument and that price should go your way, rather be the trader who always puts the size of opponent liquidity (for example buying liquidity if one is in short position) as much higher importance than your thesis or biases formed. This way one naturally decreases the impact that personal biases have on your trading performance and rather the strength of buyers and sellers at specific price levels will be much stronger driver dictating your actions. Always put what others are doing as a priority in front of your own beliefs/biases especially if sized players are participating.

This rule itself will put in a soft cage at least half of destructive biases if not more. The more you practice this, the better you eventually get, and the trades where you fight asset for the whole day become history.


It is often seen in this industry that people are sided on left or right (buyer or short seller) and the sides show as much disrespect to the other side very often within the highly biased communities especially beginners. This kind of mentality is a very toxic one, the much better one to adapt is to find as much respect to any individual because only with such approach you will give yourself a chance to understand a point of the other sided individuals (even a trader with weak and wrong thesis is worthy of understaning since he/she is still orderflow participants and so are many who think like that individual).

Disrespect leads to ignorance, and you do not want to be the type of trader who has all sorts of blind spots. In leveraged markets anyone's opinion can matter no matter how wrong it is in its concept, especially if individual has influence or capital, which means that it is your task as a trader to find understanding within such individual no matter what or who they are.


I found one very strong pattern within traders:

-Lack of respect to the other side of participants=large blind spots and much higher chance to operate with strong biases, falling the victim to them sooner or later.

But at the same time, do not idolize anyone, as that is sure way to create just as much blind spots as well, as it becomes self-reinforcing in an opposite kind of a way.


Avoid this at all costs, and the answer is hidden within the explanation above and bellow.




Anchoring bias



Let's address the first horseman of the apocalypse when it comes to trading, the anchoring bias. This is the strongest and potentially the most destructive one and it is traders' task to not fall for it. The basic premise of anchoring bias is a strong opinion which one is unable to change. For a trader, it is unacceptable to operate with this bias frequently because it will yield consistent large losses.



1. Reason for happening


One shared variable often is over-preparation. Now i don't think that there is such thing as being over-prepared because the more time trader puts into research, the better. But it is correlated driver to the potential anchoring bias. Generally, when people put a lot of time and effort into something, they are completely aware of the time sacrifice that had to be made for that, this then makes it harder for such individual to just let this thing go and admit that potential time inputted was a "waste".

Lets put it straightforwardly, nothing that you research or do is a waste of time, there are essential lessons you learn from everything, but short term people are not thinking this way. Another reason why anchoring bias might appear is that too few people doubt their qualitative analysis skills and do not stress-test their own opinions. If you never stress-test your opinions you do not have a realistic expectation on how frequently you are right. Because a person who frequently tests will understand that and will tend to form softer opinions (which is natural enemy of anchoring bias), which will decrease the chances of anchoring bias. Anchoring bias is always going hand in hand with very strong opinions. "I know I am right."



2. Potential traders behaviour




The most usual performance weakness that comes out of anchoring bias is un-ability to cut the loss on the trade. Trader is so sure about being right that as the price starts to move against him, he/she is not thinking that idea might be wrong, instead, trader is thinking that the market is wrong and irrational.



3. Potential (attempt) for solution



-test your trade idea all the time (realtime), analyze order flow to constantly check if order flow confirms or denies your thesis. Testing separates the idea/hypothesis away from one's subjectivity. Consistent testing prevents one from having a 100% sure idea basis because you are constantly seeking for weak spots in the idea itself.


-form your own ideas. Do not operate with the complex thesis that someone else made for you, this will create "deer in the headlights" effect once the price starts going the wrong way. There is a delicate balance between learning from others (which we all do) and forming your own ideas from scratch.


-Try not to put too much time into researching one specific idea. Rather put that same time and diversify it into 5 ideas. Thit way you can let those ideas go easier because there is always another potential ace that you have in your sleeve. The majority of anchoring biased traders are the ones who only have that one idea they have been building for the last 2 years without anything else in the mix.


All the above potential solutions require effort and time obviously, but if each of them is implemented it will reduce the anchoring bias negative impact with a decent rate.



4.Practice and repetition (building defense parameter against anchoring bias)


Perhaps one of the most useful steps that trader can take to place the apocalyptic horsemen of anchoring bias into the cage is simply repetition. The more ideas/positions formed, the more mistakes made, the more adaptations made, the better the trader will be in the future to control the anchoring bias.


One thing which becomes very clear is that individuals who constantly keep recycling one same idea over and over again are the most exposed to anchoring bias. Eventually, over time they tell themselves the story so many times over that it is impossible for anyone else to shake their perception even if they are completely wrong. The more they keep recycling that same old idea back and forth the stronger the anchoring bias gets, and eventually over time you get "all in", there is no secondary exit route, "it has to work". In trading such behavior is unacceptable, at this point you have accepted the role of a captain who is determined to sink with a ship in case anything goes wrong, whether you realize it or not.


To get control over anchoring bias - practice new fresh ideas as much as possible, new thesis around different financial instruments, macro play, setup, do not linger for too long on the same type of play. The more you linger on, the more it becomes like a relationship, the more time invested the harder it will be to "let it go".


And not just that, the ego itself plays a role in anchoring bias. Individuals who get to hang on their previous "good calls" tend to expand on their ego and let it impact their next play as they get too sure to be right on it. The ideal way is to start every trading day completely fresh, fully formatted. To format that HDD inside your breain called the short term memory and start every trading day with as little presence of the previous day, this way anchoring bias does not get a chance of ego to influence it. However, this is most useful once the trader already has a well-established trading routine, which might take a while.



Data over-simplification




Analyzing and researching the markets is a constant process of searching for repeatable patterns and forming trading ideas on top of them. There is a delicate balance of how deep or superficial should the searching process be. If the research process is too deep it will leave the trader with an unfinished idea and data paralysis but if the analysis process is too shallow it could lead to data over-simplification.


The core of data over-simplification is that trader is trying to fit two patterns into each other, while those two patterns are actually not the same. Basically calling two things with the same name, while in reality, they are not the same. Usually, the whole problem arises because the trader is using too few variables to identify the trading pattern or situation. With a small number of variables that identify the pattern, basically, anything can fit into it. It is important that the trader is specific and has each pattern identified trough enough robust variables and the variables have to be significant in participation. What is meant by that is that trader should not include in pattern identification variables that are so general that they are present across all the other situations which are not identified as a "pattern". Some of that was already mentioned on previous articles.


For example, let's say that trader uses the variable "net yearly cash flow" for stocks. And trader has a thesis that there is a pattern of stocks/companies with negative net yearly cash flow to have bearish overall stock performance using 1 year trading period. Which variables trader then additionally adds to that variable is going to determine if the result will be accurate or data over-simplified. If that initial variable is only added by "short % of float" variable and trader concludes that pattern is: high short % + net yearly cash flow = bearish stock performance. That conclusion would be the case for data over-simplification with too few variables and that pattern would eventually fit too many other situations that have random performance results. It is very important that trader is specific enough, to identify patterns trough many variables, and that each variable is contributing. If variable is just being a "bench-warmer" and does not contribute, then replace it with something that does contribute.


Over-simplification can very easily lead to increase of anchoring bias as once enough variables are stripped away, trader will be able to hold to any thesis very easily, for the wrong reasons very often.





Recency bias




The third horseman of the apocalypse when it comes to trading is recency bias. There are many different ways of how one could explain or define what recency bias is. One way could be, it is the result of previous market or traders' actions that affect the future next actions or analysis and skew the realistic expectations and potentially reduce the performance rate of trader or in certain cases save trader from making additional further significant mistakes. Theoretically the recency bias is meant to hae negative meaning or implication but that is not always the fact, as it could also have positive impact on short term trading decisions.



Positive and negative implications of recency bias examples:



Positive impact example:


A trader with consistent negative performance of losing trades within last several days decides that something is significantly wrong with his/her approach or performance, therefore, the trader decides to scale down position size to the minimum, or even revert to paper trading until the performance starts to improve drastically to return to previous position sizes.

This might save a trader from inflicting further significant losses, in case if there was some serious issue within the trading performance that has to be solved before trader should follow up trading with normal position sizes. This means that very near term performance (recent performance, ergo recency) impacts the decision for a trader to perform the action needed to save trading capital.

This is not black and white as it will depend on how well is trader being able to judge if there was a significant problem within trading approach or if the short term performance is just a random cluster of negative/nonperforming trades in a row (which can happen to any trader!). But for the sake of argument lets say that in this case, it was not just a random cluster of negative plays by chance but rather some external factor that trader had to address before going back to old ways (external variable).


The above example is a real-world example that many experienced traders tend to practice, where when certain personal slump of conditions is present and performance suffers, they scale down position size drastically until the conditions (outside of trading) start to improve. This is an example of where a trader will correctly rationalize that the performance is suffering due to external variables, which if not addressed will keep impacting performance potentially negatively.


Negative impact example: A trader with few winning trades in a row gets over-confident and scales position size on the next trade way too high, resulting in impacting edge with too much luck due to ego increase. Recent past few winners inflate the ego, and the negative impact could start from there, again this is only applicable to certain cases, by no means will every trader in such situation react or be impacted the same. This is just to point out that to some traders this issue will happen. Example where recency of performance impacts trader in negative way in near future.



Negative impact example 2: A trader with several losing trades who decides to fully change the trading approach just because he/she faced several losing trades in a row. In any trader's performance or playbook, there is always a cluster of losing trades hanging just around the corner, even with a play that has 70% of performance rate in traders playbook it is well within possibilities to step into the cluster of 10 losing trades in a row within that play. This will happen from time to time, and changing the whole trading approach might be very damaging in such cases.

While it is completely natural to start doubting your trading approach or the play/pattern itself in such case (whether for right or wrong reasons, it's just something that naturally happens, uncertainty combined with consistent underperformance is something that makes anyone doubt anything), it is not rational to hire a demolition team just due to this behavioral pattern.


And at this point, the reader might be confused because the example above outlines a similar case as being the positive impact of recency bias, while this case under it outlines a similar case as negative impact of recency bias.

Again it all matters on whether it is just a random chance of hitting cluster of bad trades/plays in a row, or is it something of an external variable impacting the performance. This means that traders' rationality, objectivity, and perception will play a huge role in whether the recency bias will tilt its impact on the negative or positive side.


Keep in mind, the riders of apocalypse (biases) pray upon any trader but how well you defend against will be totally dependent upon your perception and decisions being made, nothing is set in stone. No-one is by default doomed or made for success.



To highlight recency bias think of this practical example, lets say that there is a highway with a high velocity of traffic which represents large revenue and logistic importance for the country. On this highway, there are approximately 1 to 2 accidents a week (theoretical example), but then all of sudden there is one day with a cluster of 15 accidents within a single day.

If the government decided to all of sudden completely shut down such roadway due to this single day performance, would this be a rational decision? The answer is hidden within the secondary question: Did something all of the sudden change about this road? Were some changes being made? If not, then shutting such a road would make no sense whatsoever and this would be an example of recency bias impacting negatively the performance of such country. However, if some significant changes were being made which all of the sudden increased the accidents daily consistently then obviously the answer might be completely the opposite.

Think of your trading approach in the same matter. And please revert from the typical excuse that so many traders make: "Oh the market has changed, thus my performance has as well". If one has a robust playbook backed with years of historical research then this is a rubbish excuse at best or a complete miss-judgment at worst.

And while certain market conditions do change incrementally from time to time, trader should not be operating with such terms as this shows the lack of research or the lack of control that trader possesses.


Negative impact example 3: An investor who places a large sum of capital investing in assets that recently performed with a very strong % move (TSLA 2020, Bitcoin 2017, .com stocks 2000,...). This is common mistake or trap that beginners tend to fall into being victims of recency bias (combined with FOMO). The expectation of near term performance to repeat (double up).

This mistake goes hand to hand with lack of research usually and lack of experience, as a trader will just make assumption that if asset went up 500% it might just as well go up another 500% within the same time window following. And often it is very easy to justify such conclusions as there are "clues lying everywhere". Meaning if trader made the assumption that this is well within possibilities such individual will sooner or later found 100 of "confirmations" from other individuals or sources which all point into the same direction, even though that majority of those will be just as the initial trader's assumption- only assumptions or a very rough estimates without any significant consistent historical data within large sample cases.

This is by far the most common recency bias trap that nearly 70% if not more beginner traders or investors tend to fall into.




Limited data



The core issue of why recency bias appears is usually due to amount data that the trader has lack of. This is why traders often start asking questions "has the market changed?" or "why is my setup no longer working?", most of those questions is where recent history of 10 samples or 30 samples will cloud the trader's judgment because the trader does not have large sample base of data to tell that over large sample base the data is still smoothed out and well in-line with expectation, even if last 10 cases in a row all under-performed (again, it could or could not be the case, look above positive / negative cases to find the clue).


This leads to a solution, to decrease recency bias as much as possible make sure that you do not come to conclusions too early with a limited amount of data or experience (either or). Gather enough data so that you can draw a decisive conclusion, and if you do not have enough data give it enough time first before starting to make conclusions (even if that means doing full week of research).

The market does not owe anything to anyone, if that means for one to spend a few months of time without the pay just to get that required amount of data, so be it. That has to be done, regardless if that means trading on the demo environment for a while or doing hours and hours of research. If you try to take shortcuts your live trading capital is likely to be the reflection of that.


Fight recency bias with enough data and samples, this is the best shield to guard against.



Number of samples



To reduce the chance of stepping into recency bias always ask yourself, are you basing conclusions from recent history or are you basing it from the large sample base? In most cases, the answer will be recent history, which is often not a good way to go about it.

Think of it this way, to get a large sample base of any process in society you need to engage with it frequently, you need to collect a bunch of mistakes, you need to do it for a while. This means technically that most likely for majority areas in trading, most individuals will not be able to achieve it, especially since not everyone can afford to be a full-time trader or to even attempt trying it.

And without the frequency of attempts, one does not get enough samples. This is why traders prefer to speculate or assume just from their (or assets) recent historical performance on what might or might not be happening since this is a much easier / quicker way to get to the potential issue, even though that end-conclusion is very often completely deceiving.


Therefore have a focus on samples. Ask yourself, am I basing this conclusion from the history of at least 100 repetitions? Or am I basing it of just 10 or perhaps only 1 (being something you only saw once ever)? If the second question/answer is the case make sure to stop yourself from drawing any conclusion, move on, collect more samples (might not be possible always however). Else the recency bias is lurking within the shadows to catch you on the faulty move.



De-moralization



-state of mind of a person deprived of spirit or courage, disheartened, bewildered, and thrown into disorder or confusion.


One component which might enlarge the recency bias is as well the impact on morale from the recent history of bad performance. This in turn makes many individuals start to question their methods or even make them avoid trading fully, even if they can fully rationalize that the issue is just a random cycle of chance or their own subjective mistakes that impacted the result of a trade.



-Have you ever had several losing trades in a row where you started to question your whole trading approach or the irrationality of the market itself? Your mood dropped and all of sudden you start to see tin-foil hat theories everywhere, behind every trade, trader, and past decision. De-moralization impact at its best.


-Have you ever had 5 trades which were all break-even stop-outs and eventually they all worked out, which made you loosen the risk completely on the next day (causing then a larger loosing day) after which you were demoralized (blaming it on yourself as making wrong decision potentially)?


-Have you ever tried shorting several small-cap stocks in a row but your broker had by chance no borrows on either and it made you go on next day look into other brokers to open an account with them (even though that you still had a chance to short 90% of tickers over the span of the whole year with an initial broker)?


-Have you ever had several trades in a row where price comes just very close to your TP target and then fully reverses, making you on next day fully question if you are being too patient or greedy with your targets, even though that over 100 sample cases the data would still point it was the right thing to do?

.......



The answers to the above questions are very likely yes to all, and this is where when one is de-moralized (not entirely of course, but enough to be noticeable and impactful) the recency bias goes into overdrive and becomes a destructive force to your trading approach. You no longer think long term within a scope of 100 samples of what is right or wrong, instead, you become fully short-sighted. This is where adjustments to the trading approach are made and the many of those adjustments might be completely unjustified.


Those de-moralization practices are all extractions of the recency bias where the subjective psychological state leads the trading decisions and actions too much on the negative tilt. Demoralization is often the kind of a side effect where trader has no idea that recency bias is the one impacting his/her psychological and trading performance and wrong conclusions might be made from it. However with that said de-moralization will still happen to a trader who has the right perspective of long term picture in mind, it is un-avoidable the only difference is that this kind of trader will recover from it quickly and not let it impact performance too much.




Confirmation bias




This is a big one. Confirmation bias is often the most exaggerated when a trader is in losing trade or when holding to a particular idea for a long time. What it is, the trader will formulate an opinion in regards to some idea and then will seek out only specific information or opinions that confirm his/her initial idea. No seeking of counter-ideas that might disprove it, just full focus on the information that aligns with the initial thesis.


And this is where it gets problematic because, in the era of the internet where access to information is incredibly easy, one can find confirmation for anything. Anything, no matter how tin-foil hat or out of the world it is, there will be something somewhere online that will "confirm" such a thesis.


For example, one can have a short position on a ticker not going well, all it takes is to go on BAMSEC site and find fillings of the company that reveal historical dilution activities (bearish), open shelf / ATM etc... which gives trader "confirmation" to remain in position over night even if the price is moving higher. Or a short-seller might look at historical chart while being in a short position and go: "well all previous gaps faded, this just confirms this one will fade as well". And remain in position. It is very easy to find confirmations to the initial idea.


Generally, there are two specific occasions at which confirmation bias tends to increase in size:


1.When a trader is in losing position: When in losing position traders tend to seek comfort and tap-on-the-back to confirm that they do not need to close the position in loss yet since there are many individuals out there who will confirm that their idea thesis is correct. And in some cases that will be the right decision to do, where confirmation bias will impact trader positively especially if the opinions of other individuals are well researched and backed, and in some cases it might be just the opposite of that.


2. When a trader has been obsessively researching and trading a single idea or single asset for long time:

The longer that trader lingers around the same trading idea, the more the confirmation bias will play the role on the objectivity of such trade. Again in some cases with positive results and in other with negative, depending on how perceptive trader is to know how well to define good versus bad opinions and data.


Usually, traders are far more inclined to seek other individuals who share the same view as they do, rather than seeking on completely the opposite side- seeking individuals who have the exact opposite views to them. This means that traders will be more inclined naturally towards confirmation bias rather than seeking weaknesses within their own thesis as we all strive to seek to surround ourselves with people who share similar views on the world, rather than the opposite.

Keep in mind, just because someone agrees with you that does not solidify ideas at all by default, even if the number of individuals is in 100s. If the idea is wrong it matters not how many individuals share the wrong view, 0+0+0+0+0 still equals = 0. Wrong idea does not compound itself magically into right one with the replication of many confirmations.



When confirmation bias is transformed from trap into a useful tool



However, there is exactly the opposite side of the negative side of confirmation bias present as well. If the trader is able to navigate between the confirmation bias with just enough objectivity and selectivity to include only ideas or data which are considerably fact-checked and backtested as valid "confirmations" then this bias can be used as a very useful tool. Meaning if a trader can well judge which individuals are credible on their ideas and which not (but they still share similar view) this might provide the trader with slightly different confirmation that still aligns with a same directional bias on the idea, but provides slightly different view or information on the topic, which can be very beneficial. This however is only useful if trader fully understands the little details within the secondary / alternative thesis from the other individual or author which is not as easy as it sounds as it requires decent millage in the markets.



A practical example (real example of two individuals i am in close contact of idea exchange often) of that might be, let's take 2018 / 19 as an example on the gold market. Two traders both with long thesis/idea on gold, but both for a different set of reasons. Both well researched and with decent historical performance in global markets.

One of those traders is fully focused on developed markets where the long idea on gold is formed as a part of risk-off flows caused by inflationary conditions on the rise (lo interest rates, easing conditions, low growth, ...), which might provide gold a boost in the price, not just from retailers but also hedge funds and investment banks.

Another trader however is fully focused on emerging markets only where the thesis for long is the start of trading and financial de-coupling between US/China and increase of uncertainty in global markets fueling the risk flow instruments such as gold.

If both of those traders have substantial historical research with proven samples and decent performance rate then each of them can aid the other trader with strengthening the initial thesis since they are both set in the same direction. (And in hindsight as well proven correct). This is example where confirmation bias might be a useful tool rather than damaging weapon.



Again to wield the power of confirmation bias as a useful tool or a destructive mechanism will again depend on the quality of traders' perception of objectivity, research, and selectivity, just like any other bias.



Selective ignorance




One perspective that goes hand in hand with confirmation bias is selective ignorance. By that, it is meant that the individual will intentionally ignore information or views that are not aligned with his/her thesis. This means ignoring the sources/authors/individuals who hold "alternative" to their initial view and completely ignore them, or to have a full mental blockade to any information they pass out. This is something very common within crypto or Austrian economy cycles. If you hold a bearish view on gold or Bitcoin, you are automatically ignored, even if that view is very short term and reasonably supported with facts. It is the community saying "this is our cult and there is only one higher force in which we all believe if you try to come with your alternatives, you'll be kicked out". Selective ignorance is the most damaging version of confirmation bias as it fully prevents objective rationing of thesis with needed counter-balance from opposite views, which are absolutely necessary to create realistically weighted thesis.


Think of well constructed realistic thesis (time+accuracy of facts) in this way:




This then leads to a fact where people who are prone to confirmation bias will just float around the individuals who share the same view on the thesis / asset, and that will come at the expense of growth because the only way to grow and expand knowledge is to keep testing new areas, and finding the weaknesses into every thesis held by. Selective ignorance prevents any of that.


So what is the solution? Question your own views and let anyone else views be worth considering (no matter how opposite of your own) as long as they show objectivity and they have a history of delivering with consistency.



Loss aversion bias




The next rider of apocalypse comes with a name of loss aversion bias. And for the reader's sake, you might be wondering, what's with giving all those mythic apocalyptic names to those cognitive biases? Well, there is a good reason for doing so. If a trader is fully un-aware of those biases or what kind of approaches should be taken to neutralize them as much as possible, your performance is likely to suffer in a significant way, significant enough to use a bold naming scheme.



This bias is perhaps the most interesting one because it is very subtle and it varies from person to person a lot in terms of how it impacts the performance or in what kind of appearance it is present. Let me give an example.

The basic premise of loss aversion bias is that majority of humans are primarily loss aversion driven rather than profit/gain driven (survival has priority over thriving). Meaning if you can consistently avoid losing a small portion of income that is more desirable action than receiving a small portion of income while the loss is still well within the possibility of being present (case one is guaranteed evasion of loss, case 2 is possibly loss or gain).

Now this is where it gets very tricky because this will vary from person to person a lot (some are more risk-takers, some are more of safe players), it will also depend on circumstances (people with established family might be less incline to risk a lot and more inclined towards as much stability), it might even vary so much that some individuals will say what was written above is not true for them at all. Meaning they are going to pay every week for a lotto ticket on consistent basis having a highly likely (statistically) loss, just because it at least gives them a tiny chance for that big payoff somewhen down the road.


All of which means that interpretations of risk aversion bias can go into many folds, and those different types of personalities and how different individuals perceive the view on it, might differ a lot, which is exactly how it is then reflected in trading.


Some traders consistently risk large sums of equity %, and then some do the opposite of that. There are underlying economic / society /age/.... standards that define how much loss aversion plays a role.


While the basic equation outlined above is somewhat true - that we all get more pain from the loss than the joy received from gain, this equation of loss aversion is not necessarily a large driver to the behavior of traders at all. It depends from person to person. It might or might not have large influence, everyone knows the answer for themselves.

However for the sake of practicality lets layer out a few real examples of how loss aversion bias impacts a certain type of traders' personality, both in positive and negative ways.


Very conservative trader who really dislikes any losses on trading equity:


Such a trader will have a few problem areas as well as advantages of risk aversion bias. Very conservative traders will tend to have issues of missing many opportunities due to waiting too patiently for every play to be worthy of sizeable execution, or they might be too conservative on the use of very tight stop losses, all of which could be in either positive or negative side, very frequently it is somewhat a mix of both.

However, let's be honest since trading is the industry constructed of relatively younger participants, how many do suit a very conservative area, especially full-time day traders? Not many. Many more fit the label of kamikaze before they would earn a label of conservative.


Often the issue that such traders face is that they are not bold enough, they hold themselves back too much. They keep looking too frequently for those perfect opportunities while in reality, those come around much rarer than their expectations are. Trading, in general, is not an industry where for every dollar risked you can expect to get highly likely 3 dollars back on a frequent basis. And often very conservative highly risk aversive traders try to treat it this way. This does not mean that there are no such setups as 1:3 reward with decent statistical performance rate, it only means that expecting every play to turn out this way would be unrealistic that is all.


My suggestion is, as usual, the same, expand the playbook, learn more plays/markets, and for that this does not mean by default that money has to be taken at stake at the large sum. Keep trading what works, but keep expanding and learning new approaches on demo or paper-trading without taking a necessary risk so that loss aversion is not the limiting driver to traders' growth.

Because let's face it, a trader who is only looking to take one perfect trade every month is by default capping his growth potential to a huge extent. Would you expect a C league player to become semi-good while showing up at one practice and one match every month? For sure not. Practice, execution, repetition they all matter, a lot. Frequency.



High-risk taker, who is not very loss averse at all:


This is pretty much the opposite spectrum of individual, the one who does not perceive the markets or trading in terms of risk or losses versus gains, instead all he/she sees is the potential for reward. Such individuals will not fall prey to loss aversion bias as much and its potential negatives, however, such individual will fall victim to many other biases stacked in a row at much stronger peace, creating an even bigger problem. And yes few do get away with it, placing one "all-in" bet on a single instrument and get to see the fruits of it, but this blog is not about exceptions but rather about the sustainable path for the majority. Which is why I won't be going into much detail on this. And there is also however a bit of a side truth to this, being a high-risk taker is somewhat a trait that many of greatest inventors and business leaders of last 100 years had, however, there is a big difference between exceptional abilities and highly calculated risk that those were able to achieve versus the way how majority does it: place a bet and pray it works out.

Freezing (decision to not cut loss, in order to potentially avoid it):




Perhaps the most impactful on the negative side of the loss aversion bias is the freezing aspect, where trader sub-continuously decides in the middle of taken trade (after the price starts to go against his/her position) that loss will not be cut because trader does not want to end with a realized loss on the position. Trader will let that slight glimpse of luck tilt the trade over time potentially into a favorable direction so that trade can be eventually closed in green. This behavior is not strictly a result of just loss aversion bias as other components are impacting it, however, it very often is the key sole element whether the trader realizes it or not.


The larger the position size the more exaggerated the freeze effect becomes:

One noticeable thing is that if trader increases position size on particular trade drastically (for whatever the reason) the chances that freeze effect appears goes up exponentially. The more balanced the position sizes are over time, and the more equal the impact of each trade on % of equity the lesser will that effect have a chance to appear. However the more that trader introduces asymmetric trades with all of sudden very large position size, chances are that exactly those trades will be the ones where a trader will freeze.

One of reasons why it happens is that trader knows well enough ahead if this trade is a "regular losing trade/cut" the P/L impact will be in the size of several normal trades, which means it will take a while to get back up to break even as well as it will derail the morale, so often the trader will just put the plane on autopilot in such scenario and let the luck "work the trade out into the green". Such behavior should be not be shameful as this is how human is rationalizing such situation often, but the experience should give trader a guide that repeating such behavior can have very negative impact on performance.


For this reason, having a relatively stable position sizing is very important (not same share size but instead same % of equity impact), and if the trader does increase position size a lot on A-grade play (which should be done) it is that more important to be strongly disciplined and cut that trade when needed.

Is this such an easy solution to do? Not. Am I the individual and a good example of how this is done correctly every time? Not. This is a very difficult issue to solve, however, it depends a lot on the trader's personality, maturity, and the overall discipline (not just in trading) which will all determine how much the loss aversion bias will play a dangerous role in such case.



Bandwagon bias




This particular bias is an industry-standard by now in trading, and it has both positive and negative inclinations. The positives being are that over large population base the chance is that if something sticks in the society for a while, it must work. There must be a reason for it, providing a value. If there is no value to it generally over time it is being filtered out and it should disappear from the use. Now how one defines a value that might be completely subjective reasoning and all it matters if there are enough individuals who share that same perception or not.


Now with the above said, there is a huge problem as a derivate of that. As long as the value is not in any means related to actual scientific facts and the reality matters, then the value can be anything. However as soon as one establishes that value is reality+maths based value+positive societal behaviors then what becomes valuable and what becomes included in the circulation of society or trading industry all of sudden becomes a different thing.

The reason being is that at that point what provides value, it has to provide value as determined by positive trading performance, if it does not contribute to exposing the market mechanics in any sort of relevant way, then it does not provide a value potentially. At this point what it becomes is a herd effect, where everyone is using what everyone else is telling them without actually checking if there is value to it. This means that at this point it no longer is about value or reality, it just becomes a cult or a belief system. You use something that everyone else is telling you to use without questioning it.


To keep it simple:

Herd effect: Unquestionable following and use of methods established in trading industry whether they do provide edge or not.

Value based determination: Questionable approach of testing something and confirming that indeed provides value before establishing it as useful tool.


Or to sum it up, in order to avoid herd effect, the testing, questioning and continuous learning is needed to define if the use of tool / approach in community is justified or not.


This is why for example if one goes online there are about sea full of basic "strategies" on how to trade markets with simply strapping an indicator to a chart and that's all it needs to be when it comes to trading. No edge to such method but why do still 1000s of traders around the globe remain to follow and trade such strategies only to wonder later why is it not performing?

It is a belief system compounded by the bandwagon bias. Or to put a line from the movie "Just bring the shovel and don't ask any questions". Just go about it.


Also, keep in mind, the majority of those traders are all under 2 years of experience (statistics on websites, brokerages, talking to other traders, data always points towards there), which is key information to keep in mind when it comes to bandwagon bias. This is not to put anyone down, as everyone has to start somewhere but to understand this time-experience data is critical.

If it takes time to confirm/disprove any trading strategy and it even takes more time to gather required experience for knowing how to do so, and it takes even more time on live markets to switch between different trading methods then it should be no surprise that the less trading experience that traders have the more exposure to bandwagon bias there will be, and if there is a very high statistical portion of such traders within a certain method or a tool, then chances for highly deceptive perception are about to be ensured for everyone else who is new and hops on board of the deck. Blind leading the blind.


As mentioned above overall in society things that provide some sort of value remain in circulation, but keep in mind one very important factor, the majority of things that surround you as individual on daily basis have been shaped over centuries if not millennium, bit by bit. This includes large portion of daily behavioral habits (eating, sleeping, activities...), industries, educational habits, etc...

Trading meanwhile is a very young industry only a few decades old and therefore the trust factor should be that much lower for anything and anyone since the amount of testing and optimization performed over those decades is that much lesser relative to many other industries.

This is why the bandwagon bias is often skewed more towards the negative side in this industry, while for other more robust / older industries it is the opposite, it has been much more optimized towards the positive side (what sticks around, probably has stable and test-able value over many centuries).




Conclusion



This is an outlay of some of the most common biases within the trading industry and while the article does not provide necessary practical solutions for every little aspect of them, it touches the major areas on how they impact traders. There is just too much to cover in terms of all possible solutions as there are too many overlaping variables that might cause the bias in first place, which leaves it up to each individual to figure out for him/herself over time, experience and mistakes gathered.


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