How To Avoid Common Trading Biases

Prospect theory suggests that people feel the pain of losses more intensely than the pleasure of gains. This could lead individuals to take measures in trying to avoid losses, even at greater costs. As a result, many hold on to losing positions for too long, hoping for a rebound while quickly exiting the winning trades to book profits

Many studies including that of the SEBI (Stock Exchange Board of India) have reflected that majority of the traders have been incurring losses. Despite these grim statistics and warnings, many individuals are lured to trade and is continuing to rise. The primary driver behind this phenomenon is not just the pursuit of profits but psychological thrill trading provides.

Many traders are addicted to seek adrenalin rush of buying and selling even as the overall performance is negative. Additionally behavioral biases lead their own decisions towards unproductive trades, exacerbating the losses.My experience taught some of the aspects that are common and could be avoided.

Self-serving bias: Like the ‘sour grapes’ adage, many blame the markets and its fluctuations for their losses. When trade goes wrong, traders often blame external factors rather than their flawed strategies or inappropriate decisions. This prevents one from self-reflection which then allows them to reduce the instances that perpetuate the mistakes.

Overconfidence bias: This is an amplification of self-serving bias in one direction. As they attribute the gains to their skill or knowledge of the market, they assume and start to believe possessing superior skill or knowledge leading to excessive risks. Overconfidence causes them to overestimate their ability to predict market movements, resulting in poor trade execution.

Loss aversion: Prospect theory suggests that people feel the pain of losses more intensely than the pleasure of gains. This could lead individuals to take measures in trying to avoid losses, even at greater costs. As a result, many hold on to losing positions for too long, hoping for a rebound while quickly exiting the winning trades to book profits. This is also known as disposition effect in behavioral finance.

Confirmation bias: Traders tend to seek information that supports their existing beliefs while ignoring any contradictory evidence. This leads them to add up only the positive news on a stock while rejecting any negative news or warnings, leading them to ill-timed trades and losses. At times it could result to excessive trading, higher risk taking and failing to apply stop-losses.

Recency bias: Giving unwarranted importance and priority to the recent events rather than long-term trends. This could, at times, lead to panic selling for a minor correction or unfavorable information. One should’ve clear understanding of the businesses the stock is in, the sector it operates and the management quality so that short-term hiccups could be dealt with. If not followed could lead to the next usual phenomenon.

Herd mentality: The lack of information or research at the individual end could lead to exhibiting this behavior. The approach along with the crowd could benefit at times, particularly on rising trend, eventuallyturning into a bubble and to disaster as it bursts. While avoiding these manias completely could miss the chances of gains, should be approached with much more rationality to benefit from it.

Anchoring bias: This is one of the most prominent features in a trader. The fallacy of relying too much on the initial reference point especially the purchase price. Traders refuse to sell until the price returns to their ‘anchor’, even if the fundamentals worsen. That’s why they say stop-loss is an insurance in trading. Also, another common instance is fixation to generate a particular amount from the trade. A percentage return would be an ideal way than the actual quantum as the price fluctuates at each entry.

While we can’t avoid these biases overnight, we could always reduce falling prey to these. To mitigate these biases, one could follow:

A plan: Trading plan involves a pre-defined entry/exit rules along with stop-loss, position sizing, etc. ensures a rational approach.

Diligence: It’s important to stick to the plan, though willing to make changes on repeated failures. A better way is to back test and even paper trade before allocating capital.

Expectations: Consistent profitability requires skill, patience and risk management. While luck and intuition could play a bit.

Trap: We don’t run behind a menacing mouse with a mousetrap to capture it, right! Similarly, one should wait for the market to fit into their strategy rather than trying to fit their strategy to the market.

Journal: Maintain a trading journal on why a stock was bought or sold at the first place. Analyze past trades to identify the pattern of recurring mistakes and behavioral pitfalls.

Open: Be open to information whether it aligns or deviates from your thesis to avoid confirmation bias.

Even the most disciplined traders would struggle to master these invisible enemies. The key to long-term success, however, lies in self-awareness, emotional control and open for improvement.

(The author is a partner at “Wealocity Analytics” a SEBI registered Research Analyst firm and could be reached at [email protected])