Cognitive bias, according to science, occurs when judgments differ from the norm or rationality, and the “construction of reality, not objective input,” may dictate your judgment and actions. Or in other words, sometimes the brain tries to simplify information to make a decision more accessible and faster. And it’s this simplification, or reliance on a distilled version of reality can make it difficult for traders to interpret information objectively.
A variety of biases affect us in our daily lives and can cause us to see patterns that aren’t necessarily there. Below is a list of six cognitive biases traders should know and how to deal with these preconceived notions.
What are cognitive biases?
The most common cognitive biases include the following:
- Confirmation bias
- Anchoring bias
- Self-serving bias
- Optimism/pessimism bias
- Availability bias
- Risk aversion
Below you will find an explanation of each bias and some tips on avoiding it.
Confirmation bias
This is a type of bias where people look for information that confirms their original beliefs and buries their heads in the sand when they are presented with information that does not agree with their view.
For example, a trader believes that EUR/USD is going lower and will only take on board information and discussions that give credence to this view. Analysis and information that makes an objective argument that EUR/USD is going higher is dismissed, irrespective of how informed it may be.
Traders need to recognize when this is happening and keep an open mind to all views before making their minds up. Making a trading decision based only on one side of a view that you want to hear is dangerous and potentially costly.
Anchoring bias
People sometimes adopt a long-term view of a situation based on the first piece of information they read on the subject, the ‘anchor.’
For a trader, this can be very dangerous. Suppose a trader reads a bullish article on gold or cryptocurrencies, for example, and anchors their views to this article. In that case, they will always look at these asset classes through rose-tinted glasses, whatever the prevailing market tells them.
Traders should always remain open-minded and willing to change their views, however uncomfortable they may be.
Self-serving bias
In short, this is taking credit for when things go well but blaming other factors when things go wrong. This leads traders to look at themselves in an overly favorable fashion, as they believe all profits are due to their skills, but all losses are due to the fault of others.
Traders must be confident in their ability, but they must also recognize when they have made a mistake and work out why it happened and how to ensure it doesn’t happen again. Don’t let your ego hurt your P&L.
Optimism/pessimism bias
Two sides to the same coin – you’re either overly optimistic about your trade or your trading ability or overly pessimistic.
Traders with an optimism bias tend to believe that they, or their trade, will do better than it does. In contrast, a pessimistic optimism will likely mean that a trader misses a trade as the expected outcome is not up to their expectation.
Traders should be looked at with a clear mind and no preconceived ideas. Otherwise, traders will not act rationally or with the correct level of risk management.
Availability bias
This bias is commonly described as the tendency to use information readily available when making a decision. This can lead to bad decision-making as traders may base their view on readily available information instead of conducting thorough due diligence and fact-checking before entering a trade.
In essence, individuals exhibiting an availability bias enter into trades on information that is often incomplete or inaccurate. Careful consideration of fundamentals, technicals, and risk management should be implemented in decision-making.
Risk aversion
This may seem irrelevant to traders who inherently understand and can manage risk, but some traders may prefer to take lower-risk, lower-reward setups. Higher risk for higher reward – and vice versa – is an integral part of risk management and understanding. Still, when a trader goes too far toward risk aversion, trading can become a low-risk, low-reward investment. Familiarize yourself with your own risk.
